Strategic S Corp Conversion to Avoid Tax Basis Limitation

Published Categorized as Business Tax, Federal Income Tax, S Corporation Tax, Tax, Tax Deductions No Comments on Strategic S Corp Conversion to Avoid Tax Basis Limitation
tax planning using time
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Time. We can’t stop it, but we can use it. We can use it to take advantage of compounding to grow our savings. We can use it to pay down debt to increase equity. And we can use it for tax planning.

Time is one aspect of tax planning. It can help taxpayers avoid just about any tax limitation or rule that Congress or the IRS can concoct. With enough time and foresight, taxpayers should be able to outmaneuver even the most stringent tax laws. When this works, it is usually because the taxpayer controls the facts. Time allows taxpayers to change the facts over time to minimize their eventual tax liability.

But time cuts the other way too. It cuts in the IRS’s favor more than it does the taxpayers. The IRS benefits from time as the government, in theory, has an infinite amount of time. Taxpayers do not. Taxpayers cannot wait for one reason or another, and time results in a windfall for the IRS. We have covered quite a few court cases where the IRS has gained the upper hand by simply biding its time.

This brings us to the recent Spiezio v. Commissioner, T.C. Memo. 2024-64. This case involves a legal entity conversion and shows how an entity conversion can be used to circumvent the S corporation basis rules. The case is an example of how timing can make or break tax strategies.

Facts & Procedural History

The taxpayer operated a waste management business. The business was structured as an S corporation. The facts in the opinion are not clear, but it appears that the business consisted of another entity that was also an S corporation, but was subsequently converted to a disregarded entity. We’ll come back to this fact below.

The business was tied up in litigation related to pension liabilities. The court found the business liable for the pension. The parties then sued the business owner individually to hold him personally liable for the pension. The parties reached a settlement for both the business litigation and the litigation against the business owner.

The business filed its Form 1120S, as an S corporation. It reported a $2.9 million dollar deduction related to the pension liability. It then filed an amended return to remove the pension liability deduction.

The taxpayer then filed an amended Form 1040, his personal return, to report a $3.7 million dollar Schedule C loss for the pension liability. This loss produced a net operating loss, which the taxpayer sought to carry back to 2015 and 2016.

The IRS audited the loss and disallowed it, and the case ended up in the U.S. Tax Court.

S Corporation Basis Rules

To understand the S corporation shareholder basis rules, we must start with “tax basis.” Tax basis is one of the fundamental concepts for our tax laws.

Tax basis generally represents the amount of a taxpayer’s investment in property for tax purposes. For S corporation shareholders, tax basis generally refers to the investment or capital contribution the shareholder made to the business. It is a little more complex than this.

Tax basis is a floating number. It changes annually. The changes generally follow these steps:

  1. Initial Tax Basis: A shareholder’s initial basis in an S corporation is typically the amount of money and the adjusted basis of property contributed to the S corporation.
  2. Adjustments to Tax Basis: This initial tax basis is adjusted annually. Tax basis is increased by the shareholder’s share of income earned by the business (i.e., the S corporation’s annual profit), additional contributions made by the shareholder to the S corporation, and certain other adjustments. Tax basis is decreased by distributions to the shareholder (i.e., cash or property other than wages and loans paid to the shareholder), the shareholder’s share of losses and deductions (i.e., the annual loss, if any, incurred by the S corporation), and certain non-deductible expenses.

There are other rules and nuances, but these are some of the main adjustments in computing tax basis in an S corporation.

Flow Through Income or Loss

The shareholder will report the profits of the S corporation on their personal income tax return regardless of whether any distribution is made to the shareholder. Undistributed earnings or profit trigger current year income tax for the shareholder, but they also increase his or her tax basis in the S corporation.

Losses have a similar treatment. However, like profits or income, the S corporation loss that flows through to the shareholder’s personal return is limited. One of the limitations is that the loss is limited to the shareholder’s tax basis in the S corporation. This is why tax basis for S corporations is usually only an issue in a year or years when the S corporation incurs a loss. Once the shareholder’s tax basis is reduced to zero, the flow-through losses are limited. The losses are usually trapped until the S corporation shareholder has additional tax basis. There are some relatively easy ways to create tax basis, such as making loans or personal guarantees for the S corporation, which is a topic for another article (like this one on S corporation planning using loans and this one involving S corporation guarantees, or even this one involving warrants).

S Corporation Losses vs. NOLs

To understand this particular court case, we have to consider the difference between a loss by a S corporation and a net operating loss on a personal income tax return.

Unlike losses from an S corporation that are limited by tax basis, a net operating loss by a C corporation or by an individual taxpayer is different. They are not subject to tax basis limitations. Such a tax loss can be understood by considering a disregarded entity, such as a sole proprietorship. The sole proprietor generally does not have a tax basis in its business entity. This often means that they can take their business losses and offset them against their other items of income, such as a spouse’s wages, etc. If the business losses exceed the items of income, this produces a net operating loss or NOL.

There are a number of rules for NOLs, but generally, NOLs carryforward and are used going forward. This was historically not the case, as NOLs were to carry back to prior years and offset the income from prior years. Congress has monkeyed with the carryback years over time, finally eliminating the carryback starting in 2018. Importantly, NOLs are preferred as they usually result in immediate cash back to the taxpayer. The reason for this is that they carryback to a year in which income taxes were paid, the taxpayer can file an amended return to carryback the NOL and the IRS will issue a refund check to the taxpayer for the prior year.

Strategic Conversion of an S Corporation

That brings us back to this court case. In the case, the taxpayer argued that he converted his S corporation to a disregarded entity or sole proprietorship. The tax court did not find that to be the case. The court opinion is not clear on how or why this is, as it does not explain the circumstances with the second entity that does appear to have been converted to a sole proprietorship.

But had the tax court found that the facts supported that the S corporation was converted to a sole proprietorship, the idea seems to be that the pension payment was made after the entity conversion. This would mean that the loss resulting from the large payment was to be reported on the shareholder’s individual income tax return, which is how the taxpayer ultimately reported the transaction. The loss exceeded his personal income for the year, resulting in an NOL carryback.

The IRS audited the amended tax returns reporting the loss and/or NOLs and determined that the loss was incurred by the S corporation and the flow-through loss was limited by the absence of any tax basis in S corporation.

Even though the tax court did not find the facts to fit the argument in this case, one can see the potential benefit of strategically converting from an S corporation to a sole proprietorship in advance of making a large payment, such as the pension liability settlement payment.

How to Revoke an S Corporation Election

To convert an S corporation to a disregarded entity, the process typically involves several steps:

  1. State-Level Conversion: The taxpayer can start a new entity and merge the old S corporation into it, effectively dissolving the original corporation.
  2. New EIN: The taxpayer may choose to keep the same entity but obtain a new Employer Identification Number (“EIN”) and follow the IRS procedures for revoking the S corporation election.
  3. IRS Notification: Form 8832, “Entity Classification Election,” may be used to notify the IRS of the change in classification.

Taxpayers may opt to simply cease the business operations and start a new entity that does not make an S corporation election. This may be possible if there are no reasons for continuing the prior entity, such as assets or ongoing liabilities for the entity, and if doing so will not trigger other adverse tax consequences.

Timing of Conversion vs. Timing of Payment

By converting the S corporation to a disregarded entity before making a large payment, a taxpayer may be able to deduct an expense directly on their personal tax return without being subject to basis limitations. This is even better if they can generate an NOL that carries back to a prior year to trigger an immediate cash refund from the IRS, which is what the taxpayer sought in this case.

Timing is critical in such a strategy. The conversion to a disregarded entity must occur before the large payment is made. In this case, it appears that the taxpayer did not complete the conversion in time. They argued that the payment should still be deductible based on certain timing rules, but the court found that the payment was made by the business that remained an S corporation.

The taxpayer’s argument hinged on the assertion that the conversion’s effective date should align with the timing of the expense. However, the court held that since the payment was made after the merger, and by the business (which retained its S corporation status at the time), the deduction could not be claimed on the taxpayer’s personal return.

When This Strategy May Not Be Advisable

Tax planning is often highly case-specific. Strategies like this one may not always be advisable, even when they would otherwise seem to be a good fit.

For example, the S corporation conversion can trigger other tax consquences. One can be the built-in gains (“BIG”) tax. The BIG tax applies when a C corporation that has converted to an S corporation sells appreciated assets within five years of the conversion. If the S corporation holds highly appreciated assets, converting to a disregarded entity could trigger this tax, leading to an unexpected and substantial tax liability.

Other examples include an S corporation that has substantial accumulated earnings and profits (“AE&P”) from its C corporation days. Distributions from AE&P are taxed as dividends to the shareholders, potentially leading to double taxation at both the corporate and individual levels.

Legal and operational considerations must be taken into account. Merging entities, changing EINs, and dealing with state-level compliance may not always be viable. This is often the case when a business has a license or is receiving government or other payments. The non-tax complications can be complex and costly. The administrative burdens might even outweigh the potential tax benefits, especially for smaller businesses or those with simpler tax structures.

The Takeaway

This case shows one way that converting a legal entity can produce a tax benefit. It also underscores the importance of timing in tax planning strategies, such as those involving entity conversions. While converting an S corporation to a disregarded entity can provide significant tax benefits in the right circumstances, timing often matters. Failure to align the timing properly can result in disallowed deductions and unfavorable tax outcomes.

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