The numerous technical requirements for qualifying and maintaining status as an S corporation create many opportunities for loss of S corporation status.  In recognition of this, the law provides that taxpayers may get relief from accidental terminations of a corporation’s S election if the termination is “inadvertent,” the corporation takes action to correct the termination within a reasonable time after discovery, and consents to certain adjustments required by the IRS.

By contrast, if an S corporation files a statement of revocation, the IRS generally does not allow the revocation to be rescinded unless the corporation files a rescission statement before the effective date of the termination.  There appears to be no authority supporting the proposition that if a revocation was filed based on the mistake of fact or erroneous advice that the revocation can be considered inadvertent.

Could the corporation file a new S election? Generally, a corporation that terminates it’s S election may not file a new election until five years has lapsed.  In certain circumstances, the IRS may grant permission to make a new election before the five-year period expires. However, this generally requires a showing that termination was not within the control of the corporation or its shareholders or that there has since been change in ownership of greater than 50%.  There are a number of rulings in which the IRS refused to grant such relief where the basis for the revocation changed.  In a 1978, letter ruling, the IRS denied permission for early election where a revocation was made on advice of attorneys or accountants which advice was subsequently determined to be in error.

Bottom Line: Think carefully before revoking an S election, as it will likely be permanent (or at least for 5 years).

“The word abbreviation sure is long for what it means.” – Zach Galifianakis

S corporations provide valuable tax advantages for businesses with simple capital structures. Unfortunately, they are subject to stringent requirements creating multiple opportunities for missteps and potential loss of S corporation status. Recently, in. Rev. Proc. 2022-19, the IRS provided methods for addressing some such missteps, without the need to incur the time and expense to seek a private letter ruling.

The IRS guidance identifies six potential problems (1), non-identical governing provisions; (2) principal purpose determinations relating to the single class of stock requirement; (3) disproportionate distributions; (4) errors/omissions on Form 2553 (S Corporation election) or Form 8869 (Qsub election); (5) missing S Corporation confirmation letters; and (6) filing returns inconsistent with S corporation status.

Of those six issues, probably the most common is non-identical governing provisions that may create multiple classes of stock.  An example is an LLC that elects to be an S corporation but whose governing document contains language requiring liquidating distributions to be made in accordance with positive capital accounts, as opposed to a pro rata distribution as required for S corporations.  Additionally, S corporations may issue stock options which may also raise questions about whether multiple classes of stock have been created.

Under Rev. Proc. 2022-19, S corporations can correct this misstep through self-help if certain requirements are met, e.g., the corporation has not made disproportionate distributions, it timely filed its tax returns, and it identified and corrected the problem prior to discovery by the IRS. The corporation simply needs to prepare a statement of facts, an explanation of how the nonidentical governing provision was discovered and corrected, and the actions taken to establish that the corporation acted reasonably and in good faith. This document is not sent to the IRS but kept in the corporate records in the case of audit.

While a buyer of such a business may think “I can avoid any adverse tax result from invalid S status by requiring the seller to conduct an F reorganization and then purchasing the disregarded subsidiary.“ This is a common and effective strategy, although there may be some lingering concern over potential residual tax liability of the disregarded entity as the historic S corporation. And while this is a great strategy for a buyer, it does not reduce the risk to the S corporation shareholders.  Accordingly, this self-help mechanism could be valuable to such shareholders.

Bottom Line: If an infirmity in a corporation’s S corporation status is discovered, the self-help method described above may be a valuable remedy to keep in mind.

“You only live once, but if you do it right, once is enough.”  – Mae West

Tax season
Olga DeLawrence, Unsplash

On Oct. 19, 2023, the Internal Revenue Service (IRS) announced a special withdrawal process for employers that submitted claims for Employee Retention Credit (ERC) and are concerned their claims may be inaccurate.

Under the program, employers who submitted ERC claims but have not yet received a refund may withdraw their claims and avoid future repayment obligations, interest, and penalties.

The IRS created the withdrawal program to help businesses that were pressured by aggressive marketing tactics into submitting ERC claims that the businesses now believe are or may be ineligible claims.

The ERC is a refundable tax credit intended for businesses that continued to pay employees during the COVID-19 pandemic despite experiencing a significant decline in gross receipts and/or a full or partial suspension of business activities due to governmental order.

Read more here.

This is the case in California, and soon will be the case in Minnesota and New York.  For over six decades, businesses have avoided multistate income taxation relying on a federal law (P. L. 86–272) adopted in 1959.  P. L. 86–272 prohibits states from imposing income tax on income derived by an out-of-state business if the seller’s only business activity in that state is solicitation of orders for tangible personal property.  Orders must be sent outside the state for approval or rejection and filled from a point of shipment outside the state.  But if a seller accepts any orders within the state, or provides any services along with the remote sales of products, then the protections of this law do not apply.

On August 4, 2021, the Multistate Tax Commission (MTC), an intergovernmental agency that promotes uniformity across state tax codes, issued an interpretation of what types of remote interactions with a customer via website or app should be considered engaging in business activity and subjecting a seller to income taxation by the customer’s state.

California adopted that interpretation, issued guidance in 2022, and has begun enforcement via audit. [Note: this interpretation is currently being challenged in court.]  Earlier this year, the Minnesota Department of Revenue circulated a proposed notice adopting the MTC guidance. Under that guidance, activities by out-of-state businesses that would subject that business to income taxation in the state include the following:

(i) providing post-sale assistance to Minnesota customers via chat, email, or website, (ii) receiving applications via the Internet from Minnesota customers for branded credit card through its website, (iii)  inviting Minnesota residents to apply for non-sales positions via website, (iv) transferring Internet cookies onto the computers or devices of Minnesota customers for business purposes that include product development, inventory management, or market research; (v) offering and selling extended warranty plans via website to Minnesota customers; and (vi) contracting with Minnesota customers to stream digital videos and music to their devices for profit.

Bottom Line:  If your business is engaging in these activities for customers in California or New York, it is already purportedly subject to taxation. It appears that will soon be the case in Minnesota as well.

You must learn from the mistakes of others. You can’t possibly live long enough to make them all yourself. –Sam Levenson

On August 25, 2023, employers, employees and ERISA attorneys all over the nation breathed a collective sigh of relief after the IRS announced that it would provide a two-year “administrative transition” period for employers and plan administrators to coordinate and prepare for the implementation of the new Roth catch-up contribution rules expressed in SECURE Act 2.0.

By way of background, for people age 50 and older, the IRS allows additional pre-tax deferrals to their 401(k) of an annual amount in excess of the limit for those younger than 50 (“referred to as catch-up contributions”).  SECURE Act 2.0 requires catch-up contributions on an after-tax (instead of pre-tax) basis for participants who earned more than $145,000 in the prior year.

Employers began calling for a grace period almost immediately upon the rule’s announcement, which requires employees whose wages were more than $145,000 in the previous year to make catch-up contributions on a Roth (after-tax) basis . Employers were scrambling to program their payroll systems to comply with the new rule to meet the January 1, 2024 effective date. In its announcement, the IRS stated that plans that do not already provide for designated Roth contributions will continue to be deemed to satisfy the requirements of this new section during the two year transition. The IRS also stated that it intends to issue additional guidance in the future.

Bottom Line:  With the newly granted two-year administrative transition period, employers can continue to offer catch-up contributions on a pre-tax basis while they prepare their payroll systems to provide that catch-up contributions must be made on a Roth (after-tax) basis for employees with incomes higher than $145,000.

“Do things that make you happy  . . .within the confines of the legal system.”
– Ellen DeGeneres

Often times when a partnership or LLC is selling a real estate investment, some partners may be ready to cash out, while others would like to defer the gain and reinvest in real estate.  If the partnership simply sells the property and uses part of the proceeds for a like- kind exchange under Section 1031 and distributes the remaining proceeds to the cash out partners, the gain on the sale that was not reinvested would be taxable to all of the partners (not just the partners receiving the cash). This obviously is undesirable to those partners who wish to defer their gain.

What if the partnership liquidated and transferred title to all of the partners individually in anticipation of the sale and then each partner sold or exchanged as desired? The problem with this approach is that the person who engages in a 1031 exchange must have held the property for investment. The IRS has challenged transactions in which someone has acquired an interest in property and immediately engaged it in a like kind exchange.  The IRS argues that the person acquired the property not for investment purposes but for the sole purpose of selling it and therefore does not qualify.

In order to address the desires of both groups of partners, a partnership could engage in what is commonly referred to as a “drop and swap” transaction.  In this transaction, the partnership distributes a fractional interest in the real estate to those partners who want to cash out. These fractional interests are generally tenancy in common interests, known as TICs. 

At the time of sale, the buyer will acquire ownership of the property from multiple sellers (i.e. the partnership and the partners holding the TIC interests).  The partners receive their cash and the partnership (as the historical owner of the property) can use its portion of the sale proceeds to engage in a Section 1031 like-kind exchange.

Bottom Line:  A drop and swap transaction can be a great way to meet the desires of partners in a real estate partnership who have different goals and tax sensitivities.

To steal ideas from one person is plagiarism; to steal from many is research. – Steven Wright

As you are probably aware, the Federal tax code was amended in 2017 to limit the deduction that individuals can take for state and local taxes to $10,000.

As noted in prior installments of Did You Know, both Minnesota and Indiana have adopted laws that  enable owners to avoid that limitation by having their partnership or S corporation pay the income tax on the company’s income (rather than the owners pay it on their share of the income).  As a result, the company can deduct the full amount of the state income tax for federal tax purposes and the owners get a credit against their state tax liability.  The IRS has effectively blessed these structures in Notice 2020-75.

As of now, 36 states (and New York City) have adopted some form of PTE tax.   Most state legislation is effective in 2022, but several states have made their PTE tax retroactive.  For instance, Nebraska’s new PTE tax is retroactive to 2018.  While taxpayers can only amend their federal income tax returns going back three years from when it was filed, Nebraska’s law does not require prior returns to be amended, but allows prior year taxes to be paid in 2023, 2024 or 2025. This results in a current deduction against federal income taxes and the taxpayer gets a refundable state income tax credit for the prior years.

It is important to remember that these PTE tax rules vary from state to state.  In a multi-state partnership, some members may benefit while the opposite is true for others.  For example, a nonresident member may not be able to get a state tax credit in their resident state for taxes paid by the PTE thereby resulting in a higher state tax cost for them.

Bottom Line:  In structuring a purchase or sale of a business, the potential to deduct the state income tax on the gain or the ability of a seller to deduct state taxes paid in prior years could be a substantial benefit to both the buyer and the seller, but beware of collateral consequences.

If somebody offers you an amazing opportunity but you are not sure you can do it, say yes – then learn how to do it later! –Richard Branson

Taft summer associate Lauren Lambert contributed to this article.

A taxpayer who invests an amount of capital gains in a QOF generally defers recognizing the gain until the earlier of (i) the date on which he or she disposes of the QOF interest and (ii) December 31, 2026. The tax code provides investors who hold their interest for at least 7 years (or 5 years) prior to the recognition date with a basis bump that permits them to permanently exclude 15% (or 10%) of deferred gain. But even if you did not invest in a QOF prior to December 31, 2021—and thus aren’t eligible for permanent gain exclusion via the basis bumps—there may be another, less obvious way to avoid ever recognizing some of the deferred gain.

On the date of recognition, a taxpayer is required to recognize all remaining deferred gain, up to the interest’s fair market value on that date. The amount of remaining deferred gain that exceeds the interest’s fair market value on the date of recognition may be permanently excluded. For instance, if a taxpayer purchased a QOF interest by investing $500 of capital gains in a QOF, but on the date of recognition the QOF’s interest value is, for whatever reason, only $400, the taxpayer would recognize only $400 of the remaining $500 of deferred gain. The taxpayer would never have to pay federal income tax on the other $100 of gain.

There may be several reasons why a QOF investor could take the position that their QOF interest has a lower valuation. For example, the value of an interest may be discounted if it is a minority interest that offers limited ability to exert managerial control, or if there are limitations on the interest’s voting power or transferability. Additionally, changes in the underlying development may lead an appraiser to find that the development, and hence the partnership interest, is now worth less.

Bottom Line: As December 31, 2026 approaches, QOF investors should keep this less obvious gain exclusion opportunity in mind and consider whether any unique features of their own investment allow them to take advantage of it.

“If you’re going to be able to look back on something and laugh about it, you might as well laugh about it now.” – Marie Osmond

On June 14, 2023, the IRS released proposed regulations within Section 6418 Transfer of Certain Credits concerning the election under the Inflation Reduction Act of 2022 (IRA) to transfer certain energy tax credits. The industry has eagerly awaited these proposed regulations as the original statute left a number of critical unanswered questions that made the much-hyped “marketplace” for tax credits difficult to implement. Some of these questions have now been answered. Below are some observations as to what the future may entail if the regulations are finalized to match the proposed form.

  1. Tax Insurance Will Be a Staple of the Market Place

The IRA has provided a boon for the tax insurance industry as it quickly became one of the key drivers of policies. For the uninitiated, the general goal of tax insurance is to provide liquidity to a taxpayer in the event of an adverse tax result, including defense costs. In the context of the tax credits, tax insurance has already been widely adopted by the industry to cover the risk of tax credit recapture under Section 50(a) of the code, and it is not unusual for insurance to cover the tax consequences arising from tax equity financing a transaction from soup to nuts.

The proposed regulations made clear what many assumed would be the case – the risk of tax credit recapture is expressly borne by the purchaser of tax credits, and the parties are free to contract for the seller of tax credits to indemnify the purchaser against this risk. It is expected that the market will quickly coalesce to provide a synthetic indemnity for this recapture risk and pricing for tax credits will build in the cost of obtaining this buy-side tax insurance policy, which would include premiums, underwriting fees, and brokerage fees.

Read more.

This approach not only benefits the charitable cause but can also provide significant advantages for the property owner, including liquidity, tax savings, and reduction of holding costs.

A bargain sale involves selling a property to a tax-exempt charity at a price below its fair market value.  If the sale is to the right type of tax-exempt organization (known as a public charity), the seller is entitled to a tax deduction for the full fair market value of the property in excess of the amount of the purchase price received for it.  For this purpose, fair market value is the value at its highest and best use, regardless of how the seller was using the property or how the charity expects to use it.

A bargain sale can result in savings of capital gain tax in addition to a charitable deduction.  For example,  assume a building purchased for $300,000 that has appreciated to $1 million.  A contribution would entitle the owner to a deduction of $1 mil, and there would be no tax on the $700,000 of capital gain.  In a bargain sale for $600,000, the basis must be allocated proportionately between the sale and the contribution (in this case, 60/40).  Accordingly, the seller would have a $400,000 charitable contribution deduction and a $600,000 sale on which it would have $420,000 of taxable capital gain.  (A seller’s deduction is reduced by any depreciation recapture or short-term capital gain that would be taxed as ordinary income on a sale.)

These tax benefits may allow a seller to exit a difficult-to-sell property at a lower price, expedite the sales process and eliminate ongoing carrying expenses. It may allow the charity to acquire a facility for its use well below market value or to make a profit on resale.

In order to take the charitable contribution deduction, the seller must satisfy IRS appraisal requirements.  An appraisal of the property must be i) conducted by a qualified appraiser; ii) documented in a written appraisal report; iii) completed no earlier than 60 days before the date of the donation and no later than the due date of the donor’s tax return, including extensions; and attached to the tax return when claiming the charitable deduction.  Seller must also obtain a signed acknowledgment from the charity that it received the property.

Bottom Line: A bargain sale to a public charity can offer a win-win solution for property owners struggling to sell challenging real estate assets.  FYI, there are brokers that specialize in these transactions.

“Find out what you like doing best and get someone to pay you for doing it.” – Katharine Whitehorn