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Tax reform brings changes to fringe benefits that can affect an employer’s bottom line

The IRS reminds employers that several programs have been affected as a result of the Tax Cuts and Jobs Act passed last year. This includes changes to fringe benefits, which can affect an employer's bottom line and its employees' deductions.

Here’s information about some of these changes that will affect employers:

Entertainment Expenses & Deduction for Meals
The new law generally eliminated the deduction for any expenses related to activities generally considered entertainment, amusement or recreation.
However, under the new law, taxpayers can continue to deduct 50 percent of the cost of business meals if the taxpayer or an employee of the taxpayer is present, and the food or beverages are not considered lavish or extravagant. The meals may be provided to a current or potential business customer, client, consultant or similar business contact. Food and beverages that are purchased or consumed during entertainment events will not be considered entertainment if either of these apply:

  • they are purchased separately from the entertainment

  • the cost is stated separately from the entertainment on one or more bills, invoices or receipts

Qualified Transportation 
The new law also disallows deductions for expenses associated with qualified transportation fringe benefits or expenses incurred providing transportation for commuting. There is an exception when the transportation expenses are necessary for employee safety.

Bicycle Commuting Reimbursements 
Under the new law, employers can deduct qualified bicycle commuting reimbursements as a business expense. The new tax law suspends the exclusion of qualified bicycle commuting reimbursements from an employee’s income. This means that employers must now include these reimbursements in the employee’s wages.
Qualified Moving Expenses Reimbursements 
Employers must now include moving expense reimbursements in employees’ wages. The new tax law suspends the exclusion for qualified moving expense reimbursements.

There is one exception as members of the U.S. Armed Forces can still exclude qualified moving expense reimbursements from their income if they meet certain requirements.

Employee Achievement Award 
Special rules allow an employee to exclude achievement awards from their wages if the awards are tangible personal property. An employer also may deduct awards that are tangible personal property, subject to certain deduction limits. The new law clarifies the definition of tangible personal property.

At Zhong & Sanchez, we provide high-quality tax and financial reporting services to privately-held entities and small business owners. Our expertise ranges from income tax filing and accounting services to international compliance and financial analysis. Located in the Silicon Valley, you can reach us at 510-458-4451 or schedule your first consultation today at

Source: IRS

Picture credt: Jaclyn Morgan, Foodable

IRS closer to obtaining virtual currency records

U.S. taxpayers who have traded in virtual currencies such as bitcoin, but have not reported and paid tax on the income or gains from those transactions, may face the heat as the IRS continues to press for greater tax compliance in the virtual currency arena.

Some taxpayers may evade their tax obligations by concealing or otherwise failing to report their proper amount of taxable income and thus underpay their taxes, according to the IRS, and the Service has identified several tax-compliance risks associated with virtual currencies, including a lack of third-party reporting.

Tax practitioners should understand how virtual currency transactions work because their clients may already be trading in virtual currency or will be in the near future.

Documents requested by the IRS

The government has been investigating the use of virtual currency that can be converted into traditional currency for the past several years. After the IRS issued Notice 2014-21, which took the position that transactions in virtual currency were property transactions that could result in gain or loss, it then served a John Doe summons on Coinbase Inc., a San Francisco-based virtual currency exchange company, in November 2016. (A John Doe summons, which is issued under Sec. 7609(f), does not name a taxpayer because the IRS does not know the person's name.) 

Most recently, on Nov. 30, 2017, after a lengthy summons enforcement proceeding, a federal district court issued an order granting in part and denying in part the IRS's petition to enforce the summons. The court's order (Coinbase, Inc., No.17-cv-01431-JSC (N.D. Cal. 11/28/17) (order re: petition to enforce summons) requires Coinbase to produce the following documents for accounts with at least the equivalent of $20,000 in any one transaction type (buy, sell, send, or receive) in any one year during the 2013 to 2015 period:

  1. The taxpayer identification number;
  2. Name;
  3. Birthdate;
  4. Address;
  5. Records of account activity; and
  6. All periodic statements.

Once the documents are produced, the IRS will begin sifting through a vast amount of information to identify U.S. taxpayers who the IRS believes are not complying with their tax obligations. Those taxpayers may be subject to civil examinations and potentially owe tax, interest, and civil penalties. Other taxpayers with more serious issues could become subject to criminal investigation — if, for example, they have large amounts of unreported income over several years.

All of this is yet to be determined as the Coinbase case plays out. Taxpayers who think they may have exposure would be wise to take steps to comply, such as participating in the IRS domestic or offshore voluntary disclosure programs, as opposed to waiting for the IRS to catch them.

Notice 2014-21

The IRS laid the groundwork for enforcement in the virtual currency world by issuing Notice 2014-21, which provides answers to frequently asked questions (FAQs) on virtual currency, such as bitcoin. The 16 FAQs in the notice discuss the U.S. federal tax implications of transactions in, or transactions that use, virtual currency. For taxpayers trading in virtual currency, the notice is an important document to understand, and for tax professionals, the notice is a must-read. The IRS also updated its website in March 2014 to include a landing page specifically dedicated to virtual currency and providing an overview of the rules and a link to Notice 2014-21. 

The IRS's position is that virtual currency is treated as property for federal tax purposes and that general tax principles that apply to property also apply to transactions using virtual currency (Notice 2014-21, FAQ No. 1). This means that a taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value (FMV) of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received (FAQ No. 3).

Taxable income from buying goods or services

Suppose a U.S. taxpayer, J, located in Mountain View, Calif., performs software contracting services in 2015 for a client, M, located in the Netherlands. J emails M an $8,500 invoice for the work. Instead of sending a check from the Netherlands, M pays J for his consulting services by electronically transferring bitcoin to J's virtual currency account.  

Since the virtual currency is convertible, J cashes out and electronically transfers the funds to his personal bank account. Under Notice 2014-21, J has taxable income equal to the bitcoin's FMV on the date that J received the virtual currency from M (i.e., $8,500). The income is also probably self-employment income subject to self-employment tax (FAQ No. 10).

Taxable gain from buying, selling, or trading

In addition, other transactions using virtual currency trigger a reporting requirement. A taxpayer can have gain or loss upon an exchange of virtual currency for other property just as if a taxpayer sold property and in exchange received cash. Below is a quick summary of the rules:  

  • If the FMV of property received in exchange for virtual currency exceeds the taxpayer's adjusted basis of the virtual currency (the taxpayer's cost to purchase the virtual currency), the taxpayer has taxable gain.
  • A taxpayer has a loss if the FMV of the property received is less than the adjusted basis of the virtual currency (FAQ No. 6).

Capital gain or loss for property transactions, including those from virtual currency, is reported on Form 4797, Sales of Business Property, which is attached to Schedule D, Capital Gains or Losses, of a federal income tax return.

Adjusted basis of virtual currency

A critical aspect in dealing in virtual currency, and an important step that tax practitioners can assist their clients with, is maintaining adequate books and records to establish a taxpayer's adjusted basis of the virtual currency. A taxpayer's adjusted basis (or cost to purchase the virtual currency) determines the amount of taxable gain or loss.

If a taxpayer becomes the subject of a civil examination, the taxpayer, not the IRS, has the burden of proving cost basis, which normally is accomplished through contemporary documentary evidence. Without credible evidence, the IRS can take the position that the property received in the exchange is fully taxable because it has no basis.  

John Doe summons

On Nov. 17, 2016, the government filed an ex parte petition under Sec. 7609(h)(2) for an order permitting the IRS to serve a John Doe administrative summons on Coinbase, the San Francisco virtual currency exchange company, for information related to transactions conducted in convertible virtual currency (In re the Tax Liabilities of John Does, No. 3:16-cv-06658-JSC (N.D. Cal. 11/17/16)). The IRS sought the identity of U.S. persons who had not properly reported income from their use of virtual currency. 

A John Doe summons is a powerful tool for the government to discover the identity of individuals who may have failed to disclose all of their income (see Bisceglia, 420 U.S. 141 (1975)). Unlike a normal summons seeking information about a specific taxpayer whose identity is known, a John Doe summons seeks information about a group of taxpayers (Secs. 7609 (c)(3) and 7609(f); see also Internal Revenue Manual (IRM) §25.5.7, "Special Procedures for John Doe Summonses"). The IRS may issue a John Doe summons only after a court proceeding in which the government meets three requirements:

  1. The summons relates to the investigation of a particular person or ascertainable group or class of persons;
  2. There is a reasonable basis for believing that the person or group or class of persons may fail or may have failed to comply with any provision of any internal revenue law; and
  3. The information sought is not readily available to the IRS from other sources (Sec. 7609(f)).

Unlike a normal court hearing, where both sides submit briefs and participate in the hearing, the court decides the case based only upon a review of the government's petition and supporting documents (Sec. 7609(h)(2)). Coinbase was not permitted to appear in court or to file briefs. An important takeaway is that the government only needs to establish a reasonable basis for believing that a group or class of persons has failed or may have failed to comply with any provision of any internal revenue laws. No further showing is required.

In the Coinbase case, the government pointed to the following evidence, set forth in its pleadings, in support of its petition to enforce the summons:

  1. A report issued by the U.S. Government Accountability Office (GAO) regarding tax compliance issues relating to virtual currency;
  2. Notice 2014-21, where the IRS set forth its position that virtual currencies that can be converted into traditional currency are property for tax purposes;
  3. A second GAO report issued in May 2014 focusing on public policy challenges posed by the use of virtual currencies; and
  4. A signed declaration by an IRS senior Revenue Agent, who had gathered information regarding tax compliance issues posed by the use of virtual currency (In re the Tax Liabilities of John Does, No. 3:16-cv-06658-JSC (N.D. Cal. 11/17/16) (memorandum in support of ex parte petition for leave to serve John Doe summons)).

After reviewing the government's petition and supporting documents, on Nov. 30, 2016, the federal district court issued an order granting the ex parte petition for leave to serve a John Doe summons on Coinbase (In re the Tax Liabilities of John Does, No. 3:16-cv-06658-JSC (N.D. Cal. 11/30/16) (order granting ex parte petition for leave to serve "John Doe" summons)).

Summons enforcement proceedings

When the IRS served the John Doe summons on Coinbase, the company refused to comply, so the government filed a petition in federal district court to enforce it. On Nov. 28, 2017, after briefing and an oral hearing, the court issued an order enforcing the summons. A few observations are worth noting about the summons enforcement proceeding in federal district court:

  • The court found that the IRS summons served a legitimate purpose of investigating the reporting gap between the number of virtual currency and bitcoin users reporting gains or losses to the IRS. The court relied, in part, on the IRS's assertion that only 800 to 900 taxpayers reported bitcoin gains to the IRS during each of the relevant years.
  • However, the court ruled that the summons went beyond seeking relevant information and narrowed the scope to a limited category of documents.
  • The court's opinion provides insight into the scope and type of documents the government can obtain in a summons enforcement proceeding dealing with a virtual currency exchange company.

What to expect

The next step is for the IRS to begin sifting through the Coinbase data and identifying U.S. taxpayers who the IRS believes are not complying with their tax obligations by comparing the information received from Coinbase with information reported by taxpayers on their returns. Some U.S. taxpayers may be selected for audit.

The IRS will be looking for unreported income (e.g., gain from the sale or exchange of virtual currency based upon a review of a taxpayer's periodic account statements), and taxpayers may face, at a minimum, the civil accuracy-related penalty (a 20% penalty under Sec. 6662) and possibly the civil fraud penalty (a 75% penalty under Sec. 6663). In cases with larger amounts of unreported income over a number of years, the IRS could refer the case to IRS criminal investigation (see Fink, 1 Tax Controversies: Audits, Investigations, Trials §5.01 (2017)). 

Looking forward

The best course of action now for U.S. taxpayers who have used virtual currencies is to take steps to comply and minimize their exposure through, for example, the IRS voluntary disclosure process. Cases are harder to resolve, and the civil penalties can be greater, after the IRS contacts a taxpayer. Expect the IRS to be most interested in U.S. taxpayers who have traded in virtual currency. If a taxpayer is contacted, however, the following points are worth considering for tax professionals representing a client during a tax audit:

  1. Although the government has issued its position in Notice 2014-21 that virtual currency transactions are taxable as property, it is uncertain whether certain virtual currency transactions are actually subject to U.S. taxation. Tax professionals should carefully review the virtual currency exchange transactions, get a handle on the facts early on, and develop a defensible strategy as to the amount of unreported income.
  2. Notice 2014-21 recognizes that penalty relief may be available to taxpayers who are able to establish that the underpayment of tax is due to reasonable cause.
  3. Where the law is vague or unsettled on whether a transaction has generated taxable income, courts have found that the defendant lacked willfulness, which is a defense to tax evasion or the civil fraud penalty (Office of Chief Counsel, Criminal Tax Division, IRS Tax Crimes Handbook, p.  10 (2009), citing Harris, 942 F.2d 1125, 1131 (7th Cir. 1991) (involving payments by wealthy widower to mistresses where civil tax cases had held such payments were gifts); Garber, 607 F.2d 92, 100 (5th Cir. 1979) (novel issue of tax treatment of money received from sale of rare blood)). There is no question that taxation of virtual currency transaction is a relatively new and complex area of tax law.
  4. A good-faith misunderstanding of the law or a good-faith belief that one is not violating the law is a defense to willfulness (e.g., tax evasion or civil fraud penalty); a taxpayer simply may not have known that he or she had to report and pay tax on certain virtual currency transactions that the taxpayer had not converted into traditional currency (Cheek, 498 U.S. 192 (1991); Stadtmauer, 620 F.3d 238 (3d Cir. 2010)).

Compliance is key

Virtual currency tax cases are a new and evolving area of the law, and further developments are expected as cases begin to be worked by IRS agents and eventually wind their way through the agency and the courts. U.S. taxpayers who have traded in virtual currency would be wise to seek the advice of competent tax counsel, who can evaluate the case, explain the options, and develop a defensible strategy.  


5 Ways the New Tax Law Affects Paying for College

The final version of the GOP tax bill that passed last month rewrites the tax code in many ways, eliminating deductions and adding new benefits. Some of these new provisions affect those paying for college.

After public outcry on several provisions proposed in the House's tax bill, the Senate version that passed last month left many tax credits related to higher education untouched.

The new tax bill keeps the deduction for student loan interest. Additionally, the tuition waivers that graduate students receive will stay tax free, and other tax credits – such as the Lifetime Learning Credit and the American Opportunity Tax Credit – remain unscathed.

"A lot of things didn’t change that we were worried about changing – the taxation of the tuition waiver, the taxation of employer tuition assistance. We worried about that happening, but it didn’t end up happening," says Shannon Vasconcelos, director of college finance at College Coach, an admissions consulting firm.

But a few key changes will affect families and students who are financing higher education. Here are five new tax codes that may change a family's finances.

1. Deductions for interest on home equity loans and lines of credit are eliminated. Under the new tax legislation, the ability to deduct interest on home equity loans is suspended from 2018 to 2025.

"This one is a real big one that is a bummer for families," says Vasconcelos. "For a lot of families, it's the best interest rate – it's better than a lot of the education loan rates. A lot of families do tap their home equity to pay for college, so losing the deduction is going to cost them fairly significant money."

The new restrictive mortgage rules that cap interest on new loans to $750,000 will also "prevent many middle-income taxpayers from using home-equity loans in the future to fund college tuition, while generating tax-deductible interest," says Blake Christian, a CPA at Holthouse, Carlin, Van Trigt, a Southern California accounting firm.

2. Families can use 529 plans to pay for K-12 education. Families can now use qualified education expenses in a tax-advantaged 529 savings account to pay for elementary or secondary school tuition. The new tax code allows taxpayers to pay up to $10,000 per student per year in K-12 tuition.

But college experts caution some families against using this new flexibility with 529 accounts. Sean Moore, founder of SMART College Funding, worries that parents who redirect these funds to cover private school education may use the money too quickly and come up short for college.

Christian from HCVT says this benefit will largely help families with a high net worth.

3. Colleges and universities will pay a new excise tax on endowments. A new excise tax levies a 1.4 percent on a private educational institution's endowments that amount to more than $500,000 per student.

The new provision affects scores of private universities with large endowments, such as Harvard University in Massachusetts, the University of Notre Dame in Indiana and Stanford University in California, to name a few.

"It's going to cost these colleges money. How much is going to be passed on to students and parents – we don't know yet. The colleges are just now figuring out how to deal with this new tax," says Vasconcelos from College Coach.

4. Student loans discharged for death or disability are now tax-exempt. The new tax code makes death and disability discharges of federal and private education loans tax-free.

Previously, the debt cancellation would be added as income on to the taxpayer's bill. Now the cancellation of the student debt is tax-free. But the new tax code only applies to discharges that occur during 2018 to 2025.

"It's great for those families who suffer from those devastating effects. But the reality is the people that it helps are hopefully very small," says Moore from SMART College Funding.

5. Alimony for recipients is no longer taxable. College consulting experts say this provision should make it easier for custodial parents to qualify for need-based aid when filling out the Free Application for Federal Student Aid, commonly known as the FAFSA. For the most part, the FAFSA for college-bound students relies on parental information, such as tax records.

"Without alimony showing up on their tax returns, divorced custodial parents should be eligible for financial aid," says Joe Orsolini, president of College Aid Planners, a consulting organization in Illinois that helps families navigate paying for college. "This change will make is easier for them to qualify."

Even with this provision, the FAFSA uses tax records from the prior prior year – so there is a time gap to when this new tax code would benefit a custodial parent. But Orsolini says this should benefit these parents "unless the Department of Education catches on to this and changes the FAFSA."


Contractors could benefit from new tax law

The new tax law is likely to accelerate a hotly disputed trend in the American economy by rewarding workers who sever formal relationships with their employers and become contractors.

Management consultants may soon strike out on their own, and stockbrokers may hang out their own shingle.

More cable repairmen and delivery drivers, some of whom find work through gig economy apps like Uber, may also be lured into contracting arrangements.

That’s because a provision in the tax law allows sole proprietors — along with owners of partnerships or other so-called pass-through entities — to deduct 20 percent of their revenue from their taxable income.

The tax savings, which could be around $15,000 per year for many affluent couples, may prove enticing to workers. “If you’re above the median but not at the very, very top, one would think you’d be thinking it through,” said David Kamin, a professor of tax law at New York University.

The provision may also turn out to be a boon for employers who are trying to reduce their payroll costs. Workers hired as contractors, who tend to be cheaper, may be less likely to complain about their status under the new tax law.

“Firms currently have a lot of incentives to turn workers into independent contractors,” said Lawrence Katz, a labor economist at Harvard. “This reinforces the current trends.”

But it could lead to an erosion of the protections that have long been a cornerstone of full-time work.

Formal employment, after all, provides more than just income. Unlike independent contractors, employees have access to unemployment insurance if they lose their jobs and workers’ compensation if they are injured at work. They are protected by workplace anti-discrimination laws and have a federally backed right to form a union.

Those protections do not generally apply to contractors. Nor do minimum-wage and overtime laws.

“What you’re losing is the safety nets for those workers,” said Catherine Ruckelshaus of the National Employment Law Project, an advocacy group.

Traditional full-time jobs also insulate workers against the peaks and troughs in the demand for their services. Consider, for instance, the erratic income of retail or fulfillment-center workers hired in the fall and let go after the holidays.

And because companies have internal pay scales, the lowest-paid employees tend to make more than they would on the open market.

“It used to be that companies like G.M. or the local bank or factory directly employed the janitor, the clerical worker,” Professor Katz said, noting that their pay would rise along with other employees’ when the company was doing well.

Unwinding employment relationships eliminates these benefits, increasing the volatility of workers’ incomes and magnifying pay disparities and inequality.

It’s difficult to say how many workers would choose to become contractors as a result of the new provision, which for couples frequently begins to phase out at a taxable income above $315,000. Mr. Kamin said joint filers who make close to $315,000 and could transform most of these earnings into business income would find it most compelling to make the change. (It could be more compelling still if one spouse’s employer offered the couple health insurance, which many employers provide even though they aren’t required to.)

On the other hand, many individuals fail to avail themselves of existing tax deductions, like the one that freelancers can take for their expenses, said Jamil Poonja of Stride Health, which helps self-employed workers buy health insurance. That may reflect the lack of access among lower-earning workers to sophisticated tax advice.

The tax benefit could also be offset in some cases by the need for contractors to pay both the employer and employee portion of the federal payroll tax.

Many employers are already pushing the boundaries of who they treat as employees and who they treat as independent contractors.

In theory, it is the nature of the job, and not the employer’s whim, that is supposed to determine the worker’s job status.

If a company exerts sufficient control over workers by setting their schedules or how much they charge customers, and if workers largely depend on the company for their livelihood, the law typically considers those workers to be employees.

True contractors are supposed to retain control over most aspects of their job and can typically generate income through entrepreneurial skill, and not just by working longer hours.

In practice, however, many companies classify workers who are clearly employees as contractors, because they are usually much cheaper to use. And many labor advocates say the new tax deduction will encourage more employers to go that route by giving them an additional carrot to dangle in front of workers.

“The risk presented by this provision is that employers can go to workers and say, ‘You know what, your taxes will go down, let me classify you as an independent contractor,’” said Seth Harris, a deputy labor secretary under President Barack Obama.

Anything that makes workers more likely to accept such an arrangement makes it harder to root out violations of the law. That is because the agencies responsible for policing misclassification — the Labor Department, the Internal Revenue Service, state labor and tax authorities — lack the resources to identify more than a fraction of the violations on their own.

“Your chances of finding a worker that’s been misclassified if that worker has not complained are worse than your chances of finding a leprechaun riding a unicorn,” Mr. Harris said.

David Weil, the administrator of the Labor Department’s Wage and Hour Division under Mr. Obama, believes the change will add fuel to a trend that has been several decades in the making.

During that time, as Mr. Weil documented in a book on the subject, “The Fissured Workplace,” employers have steadily pushed more work outside their organizations, paring the number of people they employ and engaging a rising number of contractors, temporary workers and freelancers.

The tax law will accelerate the shift, he said, because employers who are already keen to reorganize in this way will recognize that even fewer workers are likely to object as a result of the tax benefits.

The effect of the deduction could be especially big in industries where misclassification is already rampant.

Many small-time construction contractors hire full-time workers who should be classified as employees but are kept on as freelancers or paid under the table, said Kyle Makarios, political director for the United Brotherhood of Carpenters and Joiners of America.

Mr. Makarios said the pass-through provision would encourage even more building contractors to misclassify workers, allowing them to reduce their labor costs and underbid contractors who play by the rules.

The practice by ride-hailing companies like Uber and Lyft of classifying drivers as independent contractors has long been criticized by labor advocates and plaintiffs’ lawyers. They argue that the companies control crucial features of the working relationship and hold most of the economic power.

Neil Bradley, senior vice president and chief policy officer at the U.S. Chamber of Commerce, said that gig-economy companies classify workers as contractors when it suits the needs of their business and that he did not expect that to change. He also said he did not expect firms with traditional business models to follow suit as a result of the new provision.

“I think the decision is going to be driven by the considerations” that lawyers cite, such as the amount of control a company exercises, he said, “not by this tax bill.”

But Mr. Weil was less sanguine.

“These kinds of approaches to making it easier to slide into independent contractor status reflect unequal bargaining power,” he said. “When you add to that an additional financial incentive, you’re just unwinding the whole system.”


Current developments in S corporations


  • A binding, nonjudicial settlement agreement, where available under state law, offers a practical alternative to a probate court ruling to revise a trust's terms to comply with requirements to be a qualified Subchapter S trust.
  • An extension of time to make a "closing of the books" election upon termination of an S election may be available under Regs. Secs. 301.9100-1 and 301.9100-3, a recent IRS letter ruling demonstrates.
  • If an S corporation has accumulated earnings and profits and excess passive investment income for each of three consecutive tax years, its S election terminates. The IRS waived an inadvertent termination under the facts and circumstances presented in a letter ruling request. Other letter rulings determined that certain rental income was not passive investment income.
  • The Tax Court ruled in several cases involving S corporation shareholder basis that taxpayers claimed was created or increased by debt obligations. Other court cases involved determining whether the S corporation or its employee-shareholder was required to recognize income from providing services, the effect on basis of shareholders' income inclusion under Sec. 83(b), and allocation to a bankruptcy estate of shareholders' passthrough items.

In 2016 and 2017, courts have decided several cases involving S corporations and their shareholders. In addition, the IRS has issued guidance that should be of interest to S corporation owners. The AICPA S Corporation Taxation Technical Resource Panel offers the following summary of the court decisions and IRS guidance affecting S corporations and their shareholders that the panel believes will be of interest to tax practitioners.

Final regulations under Sec. 385

The IRS and Treasury in 2016 issued proposed regulations under Sec. 385 addressing when a purported debt instrument would be recharacterized as equity for income tax purposes.1These proposed regulations caused significant concerns from an S corporation perspective because their effect on a corporation's ability to satisfy the small business corporation requirements2 was unclear. Specifically, the proposed regulations raised concerns about whether the recharacterization of a purported debt instrument as equity would cause the issuing corporation to be treated as having more than one class of stock and/or cause the holder to be treated as a shareholder of the issuing corporation. However, in the final and temporary regulations issued in October 2016, S corporations are exempt from all aspects of these regulations.3

Reforming a trust to qualify as a qualified Subchapter S trust

In two private letter rulings,4 the IRS ruled that a trust was a qualified Subchapter S trust (QSST) following its reformation pursuant to a binding, nonjudicial settlement agreement.

Under the facts of the letter rulings, the terms of a trust that provided for discretionary distributions to the descendants of the primary beneficiary during the primary beneficiary's lifetime were reformed pursuant to a binding, nonjudicial settlement agreement so that the QSST requirement limiting distributions to the current beneficiary during the beneficiary's lifetime would be satisfied.5 Under the laws of the state that governed the trust, interested parties could enter into a binding, nonjudicial settlement agreement with respect to the validity, interpretation, or construction of the terms of the trust that would be final and binding on the trustee, all current and future beneficiaries of the trust, and all other interested persons, as if ordered by a court.

These letter rulings highlight a practical alternative to a probate court ruling for modifying the terms of a trust to qualify it as a permissible S corporation shareholder. However, it is important to note that modifications to a trust, whether via a nonjudicial settlement agreement or a probate court ruling, will likely not be given retroactive effect for purposes of the trust's qualifying as an S corporation shareholder, even if effective retroactively under applicable state law.6

Extension of time granted to file a 'closing of the books' election

If an S election terminates on a date other than the first day of the corporation's tax year, an "S termination year" results, consisting of an "S short year" and a "C short year."7 Unless a closing of the books is required, the corporation's items of income, gain, loss, deduction, credit, etc., are allocated between the S short year and the C short year on a daily, pro rata basis.8 However, a corporation may elect to not have the pro rata allocation rule apply and instead assign the items of income, gain, loss, deduction, credit, etc., for the S termination year to the S short year and the C short year under normal tax accounting rules (the "closing of the books election").9 The election is made by filing a statement with the corporation's return for the C short year.10 In a recent letter ruling,11 the IRS granted the taxpayer an extension of time to file a closing-of-the-books election pursuant to Regs. Secs. 301.9100-1and 301.9100-3.

Passive investment income (Secs. 1362(d)(3) and 1375)

S election termination from excess passive investment income was inadvertent

Under Sec. 1362(d)(3), if, for three consecutive tax years, an S corporation has accumulated earnings and profits at the close of each tax year and has excess passive investment income12 for each tax year, then the corporation's S election terminates at the beginning the first day of the first tax year following the third consecutive tax year. Under Sec. 1375(a), if an S corporation has accumulated earnings and profits at the close of a tax year and has excess passive investment income for the tax year, a tax is imposed on the corporation's net passive investment income.

In Letter Ruling 201710013, the IRS determined that the termination of the taxpayer's S election under Sec. 1362(d)(3) was inadvertent, even though the taxpayer had paid the tax imposed under Sec. 1375(a) for three consecutive tax years. The taxpayer represented that it was aware that having excess passive investment income could subject it to tax but was unaware that this could cause a termination of its S election. To obtain the ruling, the taxpayer agreed to distribute its accumulated earnings and profits by making a deemed dividend election under Regs. Sec. 1.1368-1(f)(3).

ObservationNote that the deemed dividend election under Regs. Sec. 1.1368-1(f)(3) may be made on a timely filed original or amended return. Thus, provided that the period of limitation on assessment has not closed for the third consecutive tax year in which a taxpayer has accumulated earnings and profits and excess passive investment income, the terminating event may be avoided by making this election on an amended return to distribute all of the corporation's accumulated earnings and profits.

Sharecropping revenue and rental income are not passive investment income

The IRS ruled in Letter Ruling 201722019 that sharecropping revenue and rental income were not considered passive investment income under Sec. 1362(d)(3)(C)(i).

Taxpayer X was engaged in a farming arrangement with another taxpayer for sharecropping purposes whereby direct expenses including processing expenses were allocated based on the percentage of crops to which each was entitled. Taxpayer X paid all utilities, maintenance, box rent, and inspection fees and was responsible for all decisions regarding the type of crops planted and marketing efforts. In a subsequent year, a new lease arrangement was signed, where X's expenses were a percentage of rental income within a fixed range, but all property taxes were to be paid byX.

The IRS held that, based on the facts and representations made, the revenue received under the sharecropping agreement and the rental income under the lease arrangement were not considered passive investment income under the rules in Sec. 1362(d), but the rental activity could still be subject to the passive activity rules of Sec. 469.

Rental income did not constitute passive investment income

The IRS ruled in Letter Ruling 201725022 that rental income received by a corporation intending to be treated as an S corporation did not constitute passive investment income for purposes of Sec. 1362(d)(3)(C)(i).

The taxpayer owned a series of commercial buildings that were leased for medical offices and support activities. The taxpayer contracted with an independent leasing agent to provide assistance with obtaining, negotiating, and renewing leases, which required significant time and attention. The taxpayer had a standard lease agreement with its tenants indicating that the landlord was responsible for maintenance and repair activities, including building systems, lighting, lawn care, walkways, and utilities. Furthermore, the taxpayer represented that these activities were performed daily by the taxpayer, its employees, its agent, and the agent's employees. The IRS ruled that the rental income received from these activities was not passive income for purposes of Sec. 1362 but could still be subject to the passive activity loss rules under Sec. 469.

Shareholder basis

In Hargis,13 the Tax Court ruled that the taxpayer, an S corporation shareholder, failed to establish that he had sufficient basis in S corporation stock and debt to deduct the losses allocated to him from the S corporation. The taxpayer relied on his position as "co-borrower" on notes from outside lenders to the S corporation and notes from related business entities to the S corporation to support his claim of sufficient basis to claim the losses.

The court determined that the loans were made directly between the lenders and the S corporation and that the S corporation was not directly obligated to the shareholder. The court noted that none of the proceeds from the loan agreements were advanced to the shareholder but rather were paid directly to the S corporation. In addition, the shareholder was not called upon to make any payment on the notes as a co-borrower, and he was not looked to by the lenders as the primary obligor on the notes. Without a direct indebtedness from the S corporation to the shareholder, the court declined to recognize basis and disallowed the lossdeductions.

The Franklin14 case is similar to Hargis in that the taxpayer was the sole shareholder of an S corporation, and he personally guaranteed the debt of his S corporation to an outside lender. Unlike Hargis, however, the shareholder in Franklin was required to make payment to the lender on the guaranteed debt when the S corporation defaulted. The Tax Court in Franklin accepted evidence that the lender did seize and sell property of the shareholder as payment on the debt of the S corporation.

The Tax Court acknowledged that the shareholder increased his basis in the S corporation by the amount of the actual payment made under his debt guarantee. The additional basis allowed the shareholder to deduct tax losses allocated to him from the S corporation. However, no deduction was allowed in another year where the shareholder had claimed a loss but the corporation had not filed a return and there was no evidence as to the loss or anybasis.

Another debt basis case was Phillips,15 in which a 50% shareholder guaranteed debts of an S corporation. The corporation defaulted on loans, and the creditors sued the guarantors and obtained a judgment against the taxpayer. The taxpayer increased her basis for the amount of the judgments in the year that the courts awarded them to the creditors. However, she had not paid any of the judgments, and the IRS and Tax Court would not allow her to claim basis until she made payments.16

Income earned by shareholder, not S corporation

In Fleischer,17 at issue was whether an S corporation or its shareholder/employee earned income from the services provided by the shareholder/employee.

The taxpayer provided professional services to customers in exchange for commissions and fees that he assigned to his wholly owned S corporation. The taxpayer was then paid a salary from the S corporation, the remaining net income or loss of the corporation was allocated to him, and he received cash distributions.

The Tax Court's opinion in Fleischer notes a first principle of income tax: that "income must be taxed to him who earned it,"18 or, more specifically, to the person "who controls the earning of the income."19 The court noted that for a corporation, and not its service-provider employee, to be the controller of the income, two elements must be found:

  1. The individual providing the services (to the customer) must be an employee of the corporation whom the corporation can direct and control in a meaningful sense; and
  2. There must exist between the corporation and the person or entity using the services (customer) a contract or similar indicium recognizing the corporation's controlling position.

Under the facts of the case, the shareholder, in his personal capacity, entered into a contract with an unrelated party prior to forming the S corporation, and the contract indicated that the shareholder's relationship with the unrelated party was that of an independent contractor. Subsequent to the formation of the S corporation, the shareholder entered into a contract with another unrelated party in his personal capacity. There were no addendums or amendments to either of these contracts requiring the unrelated parties to begin paying the S corporation instead of the shareholder or to recognize the S corporation in any capacity.

The Tax Court held that there was no indicium for the unrelated parties to believe that the S corporation had any control over the shareholder, and therefore, the shareholder, not the S corporation, should have reported the income received under the contracts.

Inclusion of income under Sec. 83(b) creates basis for distribution

Although Austin 20 is probably most notable as an economic substance case, one of its issues involved the taxability of a "special dividend" to an S corporation's shareholders. The Tax Court determined that the S corporation "was always an S corporation" and had no accumulated earnings and profits. Thus, the "special dividend" to its shareholders qualified as a distribution under Sec. 1368(b) and was excluded from the shareholders' taxable income to the extent the distribution did not exceed their stock basis.

The shareholders had relied on certain promissory notes issued as payment for their shares to provide basis and argued that the distribution did not exceed basis. The court found that the notes lacked economic substance and rejected the argument that the shareholders had additional basis. However, as a result of other rulings in the case, the shareholders recognized income under Sec. 83(b) with respect to their shares of the S corporation's stock, increasing their basis in the stock. This increase was sufficient to absorb the distribution so that the distribution was tax-free under Sec. 1368(b).

Bankruptcy estate allocated S corporation income for entire tax year

Under Sec. 1377, generally, an S corporation must allocate its income and other tax items to its shareholders on a per-share/per-day basis. In Medley v. Citizens Southern Bancshares,21two shareholders in the same S corporation transferred their shares to bankruptcy estates in early 2014. Neither shareholder elected to split his own tax year between the pre- and post-petition period under Sec.1398(d)(2). The corporation was profitable in 2014. The trustee allocated income between the shareholders and the estates based on the number of days each shareholder had held the stock. However, the court determined that Sec. 1398(e)(1) entitled the bankruptcy estate to all of the debtor's income or loss from the bankruptcy date forward. Because income does not pass through from an S corporation to a shareholder until the final day of the corporation's tax year, and the estates were the owners of the stock on that final day, all of the debtors' passthrough items for 2014 would pass through to the estates. The Medley case followed the reasoning in Williams,22 in which a shareholder who had transferred his stock to a bankruptcy estate attempted to benefit from a portion of the S corporation's losses for the year.

Inadvertent invalid QSub election highlights trap for the unwary

It has become increasingly common for an S corporation to restructure in connection with a sale or a third-party investment. A common form of this restructuring is for the S corporation's shareholders to form a new corporation (Newco), to which the stock of the S corporation (Oldco) is contributed. A qualified Subchapter S subsidiary (QSub) election is then made for Oldco, effective as of the date of contribution. Shortly after the contribution, Oldco is converted to a limited liability company (LLC) under state law. These steps are generally intended to qualify as a reorganization under Sec. 368(a)(1)(F). An unrelated party then purchases interests of the Oldco LLC or invests in it.

In Letter Ruling 201724013, the taxpayer implemented this type of restructuring; however, the QSub election for Oldco was not filed until after Oldco had been converted to an LLC under state law. Because Oldco did not satisfy all of the QSub requirements under Sec. 1361(b)(3)(B) at the time that the QSub election was filed for it, the QSub election was invalid. The IRS granted a waiver of the inadvertent invalid QSub election under Sec.1362(f).  


1 REG-108060-15.

2 Secs. 1361(b) and (c) and associated regulations.

3 T.D. 9790.

4 IRS Letter Rulings 201614002 and 201614003.

5 See Sec. 1361(d)(3).

6 See Rev. Rul. 93-79.

7 Sec. 1362(e)(1).

8 Sec. 1362(e)(2).

9 Sec. 1362(e)(3).

10 Regs. Sec. 1.1362-6(a)(5).

11 IRS Letter Ruling 201706013.

12 Passive investment income is excessive if it constitutes more than 25% of the corporation's gross receipts (Sec. 1362(d)(3)(A)(i)(II)).

13 Hargis, T.C. Memo. 2016-232.

14Franklin, T.C. Memo. 2016-207.

15 Phillips, T.C. Memo. 2017-61.

16 The years involved predated amendments to Regs. Sec. 1.1366-2 discussed in "Final Regulations Under Sec. 385" above, so there was no discussion of whether the arrangement created a bona fide debtor-creditor relationship between the S corporation and theguarantors.

17 Fleischer, T.C. Memo. 2016-238.

18 Lucas v. Earl, 281 U.S. 111 (1930).

19 Quoting Johnson, 78 T.C. 882 (1982), aff'd, 734 F.2d 20 (9th Cir. 1984).

20 Austin, T.C. Memo. 2017-69.

21 Medley v. Citizens Southern Bancshares, No. 13-12371 (Bankr. M.D. Ala. 5/17/16).

22 Williams, 123 T.C. 144 (2004).