Current Developments in S Corporations

This year Treasury issued final regulations that provide guidance on changes made by the American Jobs Creation Act of 2004 and the GO Zone Act to the rules governing S corporations.

November 2008
by Hughlene Burton and Stewart Karlinsky/The Tax Adviser

There have been numerous tax law changes in the past few years, each of which has included provisions that affected S corporations. This year Treasury issued final regulations that provide guidance on changes made by the AJCA and the GO Zone Act to the rules governing S corporations. Specifically, the regulations address three S corporation issues:

  1. The S corporation family shareholder rules;
  2. The definition of “powers of appointment” and “potential current beneficiaries” regarding an electing small business trust (ESBT); and
  3. The allowance of suspended losses to the former spouse of an S corporation shareholder.

A major change in the AJCA was to treat family members as one shareholder. The regulations retain the provisions of Notice 2005-91 that describe certain entities other than individuals that will be treated as members of the family. In addition, the regulations clarify that the “six-generation” test is applied on the latest of (1) the date the S election is made; (2) the earliest date an individual who is a member of the family holds S stock; or (3) October 22, 2004.

A question that arises related to an Electing Small Business Trusts (ESBT) is what provisions qualify as a power of appointment. The regulations state that the ability to add beneficiaries to an ESBT is generally a power of appointment but will be disregarded to the extent it is not exercised. Another important issue for ESBTs is who is considered a potential current beneficiary. The regulations amend the definition of “potential current beneficiary” to provide that all members of a class of unnamed charities that may receive distributions are to be treated as one potential current beneficiary.

However, each named charity is treated as a separate potential current beneficiary and thus a separate shareholder. Finally, the AJCA allowed ex-spouses to use suspended losses if the ex-spouse received the S stock under a divorce decree. The regulations explain how the suspended losses should be allocated between the two spouses. The transferor spouse will be allowed to use all of a suspended loss from previous years in the year the stock is transferred. Any loss that is not used in the year the stock is transferred must then be prorated between the shares owned by the transferor spouse and the transferee spouse based on their ownership at the beginning of the succeeding tax year.

Example: A owns all 100 shares of an S corporation. As of December 31, 2006, A has a zero basis in his S corporation shares. For 2006, the S corporation has $100 in losses, which A cannot use because of the basis limitation under Sec. 1366(d)(1). On July 1, 2007, A transfers 50 shares to B, A’s former spouse, pursuant to a divorce that qualifies under Sec. 1041(a). The S corporation has an $80 loss in 2007. For 2007, the year of the transfer, A may deduct the entire $100 suspended loss from 2006 and his share of the 2007 loss [$60 = (80 × .50 for the first half of the year) + (80 × .25 for the second half of the year)] if he has sufficient basis in the S corporation stock. B can deduct her share of the 2007 loss ($20 = 80 × .25) assuming she has sufficient basis in the stock.

This article has been excerpted from The Tax Adviser. View the full article here (PDF).

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