Toll the Bells
Since 1995 to the present, the LLC has emerged as the entity of choice for the vast majority of entrepreneurs. This form of business entity owes its success to the flexibility and to the tax benefits that it affords its members.[i]
For example, there are no restrictions on (i) the ownership of equity in an LLC, (ii) the number of members it may have, and (iii) the varying classes of economic interests it may issue its members and its ability to specially allocate items of income, gain, loss and deduction.[ii] In addition, the LLC is treated as a pass-through for federal income tax purposes; it does not pay an entity-level tax on its taxable income – instead, such income is reported by and taxed to its members.[iii]
Some observers have surmised that the success of the LLC as the generally preferred form of business entity demonstrates that business owners no longer regard the S corporation as an effective vehicle through which to operate a business.
This conclusion seemingly found additional support with the introduction, in 2018,[iv] of a flat federal income tax rate of 21 percent on the taxable income of C corporations.[v]
“I’m Not Dead Yet”[vi]
Notwithstanding the foregoing developments, S corporations continue to be the most prevalent type of corporation, accounting for approximately 70 percent of the combined C and S corporation tax returns filed annually.[vii]
Of course, some of the S corporation’s staying power is attributed to the significant tax cost that would be incurred if an existing S corporation were “converted” to an LLC, which may suffice to dissuade most owners from abandoning S corporation status.[viii]
That said, the shareholders may agree to revoke their corporation’s “S” election.[ix] Although some have done so after 2017, most are concerned about the double tax – at the corporate and shareholder levels – that would attend an asset sale and liquidation of a C corporation. Others who regularly take distributions from their corporation – in addition to presumably receiving reasonable compensation for their services actually rendered to the C corporation – have determined that the resulting economic benefit or tax savings is not substantial enough to warrant the change.
In other words, the business community and their advisers can expect that S corporations will remain a part of their commercial experience for the foreseeable future.[x]
Thus, it will behoove these folks to keep abreast of the evolving legal framework for the taxation of S corporations and their shareholders. This point is borne out by a recently issued Chief Counsel Advice (“CCA”)[xi] that considered whether the “S portion” of an electing small business trust (“ESBT”)[xii] may carry to another taxable year a net operating loss (“NOL”) that was attributable to the ESBT’s pro rata share of a business loss incurred by the S corporation of which the ESBT was a shareholder.
Before discussing the CCA, and to provide some context, let’s review some ESBT basics.
ESBTs Defined
According to the Code, the term “S corporation” means, with respect to any taxable year, a small business corporation for which an election[xiii] is in effect for such year.[xiv] It then lists the definitional criteria for a “small business corporation,” including the requirement[xv] that the corporation not have as a shareholder a person other than a U.S. individual, a domestic estate, one of certain enumerated domestic trusts,[xvi] or certain tax-exempt organizations.[xvii] Among the trusts that may be a shareholder of an S corporation is an ESBT.[xviii]
In general, an ESBT is defined[xix] as a U.S. trust[xx]: (a) that is not an electing QSST,[xxi] a tax-exempt trust, or a charitable remainder trust; (b) that does not have as a beneficiary any person other than (i) an individual, (ii) an estate, or (iii) certain tax-exempt organizations; (c) no interest in which was acquired by purchase;[xxii] and (d) with respect to which an ESBT election was made and remains in effect.[xxiii]
For purposes of qualifying the corporation in which the ESBT holds stock as a small business corporation, each potential current beneficiary[xxiv] of an ESBT is treated as a shareholder; in other words, in order for the trust to be a permitted shareholder of an S corporation, each of its potential current beneficiaries must also be an eligible shareholder.[xxv]
Taxation of ESBTs
The Code provides generally that in determining the income tax liability of an S corporation shareholder for the shareholder’s taxable year in which the taxable year of the S corporation ends (or for the final taxable year of a trust which terminates before the end of the taxable year), there will be taken into account the shareholder’s pro rata share of the corporation’s (A) items of income, loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder, and (B) nonseparately computed income or loss.[xxvi]
Notwithstanding the requirement that an ESBT beneficiary be an eligible shareholder, the S corporation passthrough rules are applied not to these beneficiaries but to the ESBT itself. Thus, for purposes of (i) the pass-through of items of S corporation income, loss, deduction, or credit,[xxvii] (ii) the adjustments to basis of shareholder’s stock,[xxviii] and (iii) the treatment of distributions by an S corporation,[xxix] the ESBT itself is treated as a separate taxpayer[xxx] – its pro rata share of the S corporation’s income does not flow-through to the beneficiaries.[xxxi] In addition, any gain from the disposition of the S corporation stock is taxable to the ESBT;[xxxii] the ESBT is not entitled to a deduction for distributions to its beneficiaries.[xxxiii]
Separate Portions
More specifically, the trust is treated as two separate trusts for purposes of the income tax.[xxxiv] The portion of an ESBT that consists of stock in one or more S corporations is treated as one trust (the “S portion”).[xxxv] The portion of the trust that consists of all the other assets in the trust is treated as a separate trust (the “non-S portion”).[xxxvi]
The amount of tax imposed on the S portion is determined with certain modifications,[xxxvii] including the following: the amount of tax imposed on the ESBT is determined by using the highest rate of tax applicable to individuals with respect to ordinary income or long term capital gain, as the case may be;[xxxviii] and the only items taken into account by the S portion are the ESBT’s pro rata share of the S corporation’s income, loss, deduction, or credit,[xxxix] and any gain or loss from the ESBT’s disposition of stock in an S corporation.[xl]
If an ESBT owns stock in more than one S corporation, items of income, loss, deduction, or credit from all the S corporations are aggregated for purposes of determining the S portion’s taxable income.[xli]
However, the adjustments to the basis in the S corporation stock of each S corporation[xlii] must be determined separately with respect to each S corporation. Accordingly, items of income, loss, deduction, or credit of an S corporation that are taken into account by the ESBT can only result in an adjustment to the basis of the stock of that S corporation and cannot affect the basis in the stock of the other S corporations held by the ESBT.[xliii]
Rules otherwise applicable to trusts apply in determining the extent to which any loss, deduction, or credit may be taken into account in determining the taxable income of the S portion.[xliv] For example, the Code provides that the benefit of the deduction for NOLs is allowed to estates and trusts, generally.[xlv]
Upon the termination or revocation of an ESBT election, if the S portion has an NOL, a capital loss carryover,[xlvi] or deductions in excess of gross income, then any such loss, carryover, or excess deductions are allowed as a deduction to the trust, or to the beneficiaries succeeding to the trust property of the trust if the entire trust terminates.[xlvii]
Now let’s turn to the CCA.
The CCA: Scenario and Analysis
An S corporation incurred an NOL in its X taxable year, meaning that during that year its allowable deductions exceeded its gross income.[xlviii] The S corporation passed this NOL through to its sole shareholder, an ESBT.
The ESBT had sufficient basis in its stock to fully claim the loss.[xlix] However, the trust did not have sufficient income in its S portion to cover the loss, thus creating an NOL at the trust level.[l]
The Office of Chief Counsel considered whether the ESBT could carry its NOL to its Y taxable in which the ESBT could use the NOL against the income of the S portion of the trust for that year.
Loss Limitations
For any taxable year, the Code generally allows a taxpayer to deduct an amount equal to the taxpayer’s NOL carryover to such year.[li]
S corporation shareholders generally take into account in their current taxable year their pro rata share of the S corporation’s items of income, gain, loss, deduction, or credit allocated to them.[lii]
In the case of an individual S corporation shareholder who is allocated a loss from the corporation, if the amount of the loss exceeds the shareholder’s gross income for the taxable year, the shareholder may sustain an NOL, which the shareholder may carry to another taxable year and claim an NOL deduction for purposes of determining their taxable income for the carryover year.
The Code provides that the aggregate amount of losses and deductions taken into account by an S corporation shareholder for any taxable year may not exceed the sum of (A) the adjusted basis of the shareholder’s stock in the S corporation and (B) the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder.[liii]
In general, any loss or deduction which is disallowed to a shareholder for any taxable year by reason of this basis limitation rule is treated as having been incurred by the corporation in the succeeding taxable year with respect to that shareholder.[liv]
But the shareholder’s ability to use the losses flowing through in the current year, that are not impaired by the basis limitation rule, may be limited for various other reasons, including when the shareholder’s current year income is less than the amount of their losses,[lv] or when other provisions of law – such as the “at-risk” rules,[lvi] the passive loss rules,[lvii] or the “excess business” loss rules[lviii] – result in the suspension of such losses.[lix]
ESBT Tax Rules
However, if such a loss is allocated to the S portion of an ESBT and creates a trust-level NOL, the special income tax rules applicable to ESBTs, described earlier,[lx] are also implicated.
These rules seem to have raised questions in the minds of some taxpayers regarding whether such an NOL may be carried over to another taxable year of the trust and taken into account by the S portion of such trust in that other year.
Specifically, some taxpayers interpreted the regulation[lxi] that describes what happens to the NOLs of the S portion of an ESBT upon termination of the trust as implying that there was a limit on the use of NOL carryovers by the S portion during its existence.
After acknowledging there was some uncertainty in this area, the CCA proceeded to relieve taxpayers’ concerns.[lxii]
The CCA affirmed that the rules otherwise applicable to trusts apply in determining the extent to which a loss or deduction may be taken into account by the S portion of an ESBT.[lxiii]
Under those rules, the CCA continued, a trust would normally be able to carry over a loss that passed through an S corporation, using the rules applicable to NOLs.
According to the CCA, if an ESBT owned stock in two S corporations, it would clearly be able to offset flow-through gain from one with a flow-through loss from the other because the corporations’ separate items of income, gain, loss, deduction, or credit are aggregated for purposes of determining the S portion’s taxable income.[lxiv]
However, under the narrower reading raised by some taxpayers, the CCA explained, the use of losses from one corporation against gain from that same corporation would be disallowed if they occurred in different taxable years, a result that the CCA characterized as nonsensical in light of the aggregate treatment for multiple corporations, described above.
The CCA stated that if a loss flowing through to the S portion of an ESBT under the S corporation rules cannot be used in the current taxable year because of the lack of offsetting income, the loss is nonetheless an item “taken into account” by reason of those rules in the subsequent year, in which it would be deductible under the rules applicable to NOLs.
To hold otherwise, the CCA stated, would defeat the direction of the regulations[lxv] that the rules “otherwise applicable to trusts apply in determining the extent to which any loss, deduction, or credit may be taken into account,” and providing that the NOL deduction should be “generally” available.[lxvi]
Thus, the S portion of the ESBT may carry to another taxable year the NOL passed through from the S corporation for an earlier year.
All’s well that ends well.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] For purposes of this post, we assume that the LLC has at least two members, has not elected to be treated as an association (taxable as a corporation), and is treated as a partnership. Reg. Sec. 301.7701-3.
[ii] For example, some more senior, or preferred, as to others. Of course, special allocations must have substantial economic effect. IRC Sec. 704(b).
[iii] At a top federal income tax rate for individuals of 37% with respect to ordinary income, and a top rate of 20% with respect to long-term capital gain. IRC Sec. 1.
[iv] As part of the Tax Cuts and Jobs Act (Pub. L. 115-97).
[v] Instead of the graduated rates that applied previously, including a top marginal rate of 35% that was applicable for taxable income in excess of $75,000. IRC Sec. 11.
[vi] Monty Python anyone?
[vii] https://www.irs.gov/pub/irs-pdf/p16.pdf.
[viii] Such a conversion, however accomplished, will require the actual or deemed liquidation of the S corporation for tax purposes, as a result of which the S corporation will be treated as having sold its assets, the gain from which would be reported by its shareholders on their individual returns. IRC Sec. 336 and 1366. It’s also possible that the shareholders will have gain on the deemed liquidation of their equity in the corporation. IRC Sec. 331.
[ix] IRC Sec. 1362.
[x] At least until someone in our dysfunctional government decides to change the law. Anyone remember the provision in the Administration’s Build Back Better proposal that would have allowed the tax-free conversion of an S corporation into an LLC that was not treated as a corporation. As I recall, it was eliminated in the House Rules Committee.
[xi] CCA is written advice or instruction prepared by any National Office component of the Office of Chief Counsel that is issued to Field or Service Center employees of the Service or Field employees of the Office of Chief Counsel, and conveys any legal interpretation of a revenue provision, any Service or Office of Chief Counsel position or policy concerning a revenue provision, or any legal interpretation of State law, foreign law, or other Federal law relating to the assessment or collection of any liability under a revenue provision. CCA includes both taxpayer specific and nontaxpayer specific advice.
[xii] IRC Sec. 1361(e) was added to the Code in 1996, effective for tax years beginning after Dec. 31, 1996. Congress recognized that the shareholders of S corporations needed more flexibility in planning for the disposition of their shares while maintaining the passthrough nature of the corporation. The ESBT election accommodated the use of trusts that provided for discretionary distributions among several beneficiaries.
[xiii] Under IRC Sec. 1362(a).
[xiv] IRC Sec. 1361(a)(1).
[xv] IRC Sec. 1361(b)(1)(B).
[xvi] Described in IRC Sec. 1361(c)(2).
[xvii] IRC Sec. 1361(b)(1).
[xviii] IRC Sec. 1361(c)(2)(A)(v).
[xix] IRC Sec. 1361(e)(1)(A); Reg. Sec. 1.1361-1(m)(1).
[xx] IRC Sec. 7701(a)(30).
[xxi] IRC Sec. 1361(d).
[xxii] This refers to the beneficial interest itself, not to the stock acquired by the trust. Reg. Sec. 1.1361-1(m)(1)(iii).
[xxiii] Under IRC Sec. 1361(e).
[xxiv] A potential current income beneficiary is, with respect to any period, any person who at any time during such period is entitled to, or in the discretion of any person may receive, a distribution of principal or income from the trust; Reg. Sec. 1.13161-1(m)(1)(ii)(B).
[xxv] There is an exception. Reg. Sec. 1.1361-1(m)(1)(ii)(D) provides that a nonresident alien is an eligible beneficiary of an ESBT, but Reg. Sec. 1.1361-1(m)(4)(i) provides that such an individual is not treated as a shareholder in determining whether a corporation is a small business corporation.
[xxvi] IRC Sec. 1366(a).
[xxvii] IRC Sec. 1366.
[xxviii] IRC Serc. 1367.
[xxix] IRC Sec. 1368.
[xxx] IRC Sec. 641(c).
[xxxi] IRC Sec. 641(c)(2)(C)(i).
[xxxii] IRC Sec. 641(c)(2)(C)(ii).
[xxxiii] IRC Sec. 641(c)(3)(B); Reg. Sec. 1.641(c)-1(i).
[xxxiv] IRC Sec. 641(c)(1). That said, the trust still has a single EIN and files one tax return. Reg. Sec. 1.641(c)-1(a).
[xxxv] Reg. Sec. 1.641(c)-1(b)(2).
[xxxvi] Reg. Sec. 1.641(c)-1(a). The taxable income of the non-S portion is determined by taking into account all items of income, deduction, and credit to the extent not taken into account by either the grantor portion or the S portion. Reg. Sec. 1.641(c)-1(g).
[xxxvii] Reg. Sec. 1.641(c)-1(d).
[xxxviii] Reg. Sec. 1.641(c)-1(e).
[xxxix] IRC Sec. 641(c)(2). Reg. Sec. 1.641(c)-1(d)(2)(i) provides in general that the S portion takes into account the items of income, loss, deduction, or credit that are taken into account by an S corporation shareholder pursuant to IRC Sec. 1366 and the regulations thereunder.
[xl] Reg. Sec. 1.642(c)-1(d)(3).
[xli] Reg. Sec. 1.642(c)-1(d)(2)(iii).
[xlii] Under IRC Sec. 1367.
[xliii] Reg. Sec. 1.642(c)-1(f).
[xliv] Reg. Sec. 1.642(c)-1(d)(2)(i).
[xlv] IRC Sec. 642(d).
[xlvi] Under IRC Sec. 1212.
[xlvii] IRC Sec. 642(h); Reg. Sec. 1.641(c)-1(j).
[xlviii] IRC Sec. 172(c) and (d).
[xlix] IRC Sec, 1366(d). Note that the S corporation’s indebtedness is not allocated among its members to increase their stock basis. Compare tax partnerships. IRC Sec. 752.
[l] It is assumed that the other loss limitation rules, mentioned below, were not implicated.
[li] IRC Sec. 172(a).
[lii] Under IRC Sec. 1366(a)(1). The character of such item is determined as if it were realized directly from the source from which it was realized by the corporation, or incurred in the same manner as incurred by the corporation. IRC Sec. 1366(b).
[liii] IRC Sec. 1366(d)(1). In general, if the indebtedness bears adequate stated interest that is payable at least annually, the lender’s basis for the indebtedness should be equal to its the face amount.
[liv] IRC Sec. 1366(d)(2).
[lv] Resulting in an NOL.
[lvi] IRC Sec. 465.
[lvii] Under IRC Sec. 469.
[lviii] Under IRC Sec. 461(l).
[lix] Such suspended losses will be deductible in other taxable years only as specifically authorized by the relevant provision.
[lx] IRC Sec. 641(c)(2)(C).
[lxi] Reg. Sec. 1.641(c)-1(j).
[lxii] Created in part by commentators’ speculation as to the meaning of an earlier CCA.
The ESBT described in that CCA received NOL carryovers from another taxpayer, a decedent’s estate, under the special rule of IRC Sec. 642(h)(1), which allows NOLs to be carried over from the estate to a successor rather than lost at the estate’s termination. The ESBT never had an IRC Sec. 1366 item related to those losses.
[lxiii] Reg. Sec. 1.641(c)-1(d)(2)(i).
[lxiv] Reg. Sec. 1.641(c)-1(d)(2)(iii).
[lxv] Reg. Sec. 1.641(c)-1(d)(2)(i)
[lxvi] Reg. Sec. 1.642(d)-1.
