Corporation, Securities
& Business Law Forum
April 2001 Vol. 46, No. 3
Statements or expressions of opinion or comments appearing herein are those of the editors or contributors, and not necessarily those of the association or section.
Contents
* Recent developments affecting subchapter S corporations
* Structuring a business organization to reduce exposure to self-employment tax indicence
* Establishing a protectable interest: forward thinking for clients that use restrictive covenants
This edition of the newsletter has several interesting articles, including an update on this year's changes to the Illinois Securities Law from David Finnigan and Cheryl Goss Weiss, both of whom are senior counsel with the Illinois Department of Securities. In addition, we present an article that discusses recent developments affecting Subchapter S corporations. We also present an article on structuring business organizations to reduce exposure to the self-employment taxes.
This edition also contains an informative article that discusses the process of establishing protectible interests in connection with the use of restrictive covenants. We also present an article discussing the recent case of SEC v. Brennen, in which the Second Circuit Court of Appeals examined an offshore asset protection trust. This edition also contains our regular column--BusinessLaw Flash Points (also available at IICLE's Web site www.IICLE. com). Several recent developments of note are discussed in this column.
Finally, we look forward to your comments and suggestions. We also welcome your submissions to the newsletter.
David E. Doyle
10 S. La Salle Street.II
Suite 3500
Chicago, Illinois 60603
312/606-0529
By David Finnigan and Cheryl Goss Weiss
On January 1, 2001, the following amendments to the Illinois Securities Law of 1953 become effective. The new amendments include several substantive changes that will be of importance to securities practitioners, as well as a number of clarifying changes.
The section 2.5a definition of "Offer" has been amended to clarify that the term includes offers that were made electronically.
Language in the section 2.9 definition of "Salesperson" has been amended from "wholly owned" to "majority owned" to make it consistent with the language in the securities exemption at section 3.N.
Section 2.12b has been amended to include in the definition of "Investment Adviser Representative," ("IAR") anyone who "solicits, refers, offers, or negotiates for the sale of, or sells, investment advisory advice." The effect is to include solicitors in definition of IAR's who are required to register with the State.
The section 3.C securities exemption was amended to exempt Bank Holding Companies from registration. The amendment was made in recognition of the high level of federal regulation of bank holding companies, which the Department of Securities noted in the non-binding noaction opinion given in 1997 in Marengo Bancshares.
The amendment to the section 3.Q securities exemption clarifies that 3.Q. applies to, among other things, stocks incorporated by reference to the List of OTC Margin Stocks by the Board of Governors of the Federal Reserve System.
Recent developments affecting subchapter S corporations
By Gene A. Petersen, Husch & Eppenberger, LLC, Peoria
1. The disregarded entity--QSSS
An S corporation may permissibly own any portion of the stock of another corporation (with few exceptions), and if such other corporation is wholly-owned by the S corporation the S corporation may elect to treat it as a division of the S corporation. The wholly-owned corporation is known as a qualified Subchapter S subsidiary ("QSSS") and is generally a disregarded entity for income tax purposes.
* QSSS allows separate line of business to be operated with limited liability, i.e. creditor protection.
* Election made by parent.
* QSSS not treated as separate entity for tax purposes.
* When QSSS election is made, the subsidiary is generally deemed to have liquidated into the parent S corporation.
Final Regulations relating to QSSS have now been adopted in 2000. Some points of note regarding QSSS:
* Election still to be made on Form 966 (since IRS has not issued a specific form).
* Election may be effective when it is filed or up to two months and 15 days (rather than 75 days) prior thereto or up to twelve months after the date of filing.
* The general deemed liquidation rule upon election of QSSS does not apply in certain instances such as when S corporation forms new subsidiary and immediately elects QSSS.
2. Employee stock ownership plan ("ESOP") as shareholder
Beginning January 1, 1998, an ESOP is a permissible shareholder in an S corporation. Some of the new rules in this regard include:
* The trust (of the ESOP) is treated as a single shareholder for purposes of the 75 shareholder limit.
* S income is not unrelated business income to the ESOP.
* ESOP may provide that distribution to participants will be made only in cash and not employer securities.
* Code section 1042 deferral not available for sale of shares in S corporation.
* Deduction for ESOP contributions generally limited to 15% for S corporation, and amounts used to pay interest are not separately deductible.
* S corporation which is wholly-owned by its ESOP will not be taxed on its annual income.
3. Unrelated business income
Shares of a corporation may be held by a tax-qualified plan (including an IRA) without precluding S status for the corporation. The S income allocated to the plan (other than an ESOP) is considered income from an unrelated trade or business and subject to income taxation (even if income is otherwise possible). In addition, gain resulting from the sale of the shares of the S corporation by the plan is likewise subject to unrelated business taxable income treatment.
4. Gitlitz v. Commissioner, 182 F.3d 1143 (10th Cir. 1999)
Note: Writ of certiorari granted, Gitlitz v. Commissioner, 120 S. Ct. 1830 (U.S. 2000)
David Gitlitz and Philip Winn each owned half of an S corporation that was a partner in a real estate partnership. In 1991, more than $4.1 million of the partnership's debt was discharged, over $2 million of which could be attributed to the S corporation. Code section 61(a)(12) includes the cancellation of a debt in gross income. However, the S corporation was insolvent and under Code section 108(a)(1)(B) cancellation of debt income is excluded if the taxpayer is insolvent. The shareholders' suspended losses from the S corporation because their bases in the corporation's shares did not allow the losses to be deducted. To prevent double taxation of subchapter S corporate income upon distribution to shareholders, section 1367 of the Code requires shareholders to adjust their bases in corporation's stock. Therefore, the shareholders claimed increases in their stock bases equal to their prorata shares in the cancellation of debt income.
The Tenth Circuit said that the appropriate methodology for this situation is as follows:
1. Calculate the debt discharge income for the corporation.
2. Calculate net operating loss for the corporation. (Here, it was equal to the debt discharge income.)
3. Apply the excluded discharged debt to reduce the corporation's tax. (Here, the corporation's cancellation of debt income was fully absorbed.)
4. Therefore, there were no items of income to pass through to the shareholders.
5. Furthermore, the court said that the suspended losses effectively disappear and have no future tax consequences.
5. Hogue v. United States, No. 99-302-KI, 2000 U.S. Dist. LEXIS 601 (D. Or. January 3, 2000)
This decision rejects the view of Gitlitz v. Commissioner. The court held that an insolvent S corporation's cancellation of debt income does increase the shareholders' stock bases, allowing them to deduct suspended losses from previous years. According to the Hogue court, the approach in Gitlitz is against the plain meaning of the statute.
6. United States v. Farley, 202 F.3d 198 (3rd Cir. 2000)
This decision also rejects the view of Gitlitz v. Commissioner. The court held that an insolvent S corporation's cancellation of debt income does increase the shareholders' stock bases, allowing them to deduct suspended losses from previous years.
7. Pugh v. Commissioner, 213 F.3d 1324 (11th Cir. 2000)
This decision also rejects the view of Gitlitz v. Commissioner. The court held that an insolvent S corporation's cancellation of debt income does increase the shareholders' stock bases, allowing them to deduct suspended losses from previous years.
8. Sleiman v. Commissioner, 187 F.3d 1352 (11th Cir. 1999)
The Eleventh Circuit held that when a shareholder of an S corporation guarantees a loan given to the S corporation, the loan is not treated as one from the shareholder to the S corporation that increases shareholder's basis in the corporation. Previously, in Selfe v. United States, the Eleventh Circuit had held that a shareholder's basis was increased in these situations if he borrowed the funds and advanced them to the corporation. In this case, the shareholders involved never pledged any personal assets to secure the loans which distinguishes it from Selfe.
9. Culnen v. Commissioner, 79 T.C.M. (CCH) 1933 (2000)
The Tax Court held that a direct transfer of funds to an S corporation from another company that a shareholder controls can increase the shareholder's basis in the S corporation. The transfers involved were treated as loans to the shareholder from the transferring company. The S corporation then treated the transfer as an obligation owed to the shareholder which increased his basis in the corporation shares. The increased basis allowed the shareholder to deduct losses passed through the S corporation.
10. Private letter ruling 200026011
The IRS ruled that after an S corporation undergoes a proposed recapitalization where shareholders receive one share of voting stock and ten shares of nonvoting stock for each share of voting stock currently held (the only distinction between the two shares is the voting rights), the new stock will not be treated as a different class of stock within the meaning of Code section 1362. Therefore, the S election will not be terminated. Furthermore, the IRS ruled that the recapitalization is a transfer under Code section 2701, but qualifies for the exception under regulation § 25.2701-1(b)(3) which means the recapitalization is not considered a gift under these circumstances.
11. Private letter ruling 199930025
Shareholders' agreement provides for redemption of nonvoting shares with price determined in accordance with generally accepted accounting principles. The agreement does not create a second class of stock with respect to the nonvoting shares.
12. Significant Service Center Advice (SCA) No. 199929036
The Internal Revenue Service determined that a return for an S corporation filed on Form 1120 may still constitute a valid return if:
1. there is sufficient data to calculate tax liability;
2. there is an honest and reasonable attempt to satisfy the requirements of the tax law; and
3. there is an execution of the document under the threat of perjury.
13. Private letter ruling 199928026
IRS is more lenient in allowing S elections which are not timely filed. If there is reasonable cause for filing the election (Form 2553) late, the IRS may nonetheless allow it. In this ruling, there was a misunderstanding between the corporation's president and its professional advisors as to who would prepare and file the election. The misunderstanding between the parties involved was considered reasonable cause for the submitting the election late. The late filing was treated as timely.
14. Private letter ruling 200010022
A wholly-owned subsidiary of an S corporation can, if so elected, be treated as a qualified Subchapter S subsidiary. Assets of the subsidiary are treated as being transferred to and held by the parent. The ruling indicates the deemed transfer does not result in gain or loss to the parent where the subsidiary was an existing S corporation before its stock was transferred to the parent in exchange for stock of the parent.
15. Private letter ruling 200013022
Rent from industrial property and parking lots is not passive income for S corporation which was responsible for providing significant services including maintaining roof, foundation, sewer, plumbing, and electrical fixtures, paving lots, and maintaining fencing. The level of services are considered significant enough to avoid passive income treatment.
Structuring a businessorganization to reduce
exposure to self-employment tax incidence
By William Alexander Price, Esq., Wheaton, Illinois
So long as it is possible to structure payments as due to the organization in general, and not to the organization as fees for work that must be performed by an investor individually, use of a corporation with subchapter S election, rather than a limited liability company, would appear to minimize self-employment tax, while retaining pass-through tax treatment (no entity level tax would apply.) The other option is use of a Limited Liability Company structured to make an investing member's participation meet the tests for limited partner status, or a limited partnership organizational structure with the same person holding both general and limited partner status for different percentages of ownership. The LLC would severely limit such a partner's control over the organization. The LP would subject the person to liability, so an additional corporation to hold the general partner percentage would be needed, and that organization's dividends would need to qualify for distributions free of self-employment tax.
Self-employment tax options
The self-employment tax rate is 15.3%, which represents both Social Security tax and Medicare tax. The Social Security portion is capped after taxes are applied to $72,000 of income, while Medicare taxes (2.9% of the 15.3%) are not limited. Self-employment taxes are due on wages, but not on corporate dividends. Federal unemployment insurance taxes also generally apply, as do state unemployment insurance taxes, to income not derived from
self-employment, though the statutory test for income subject to unemployment insurance tax (see, e.g., section 212 of the Illinois Unemployment Insurance Act, 820 ILCS 405/212) is broader than that expressed in the Internal Revenue Code.
Limited liability company or other organization taxed as a partnership
The Internal Revenue Service issued proposed regulations in 1997 relative to the application of Internal Revenue Code Section 1402(a)(13) which have not been incorporated into final regulations, but which still are useful in determining what they will regard as taxable. Under these guidelines:
Generally, an individual will be treated as a limited partner under the proposed regulations unless the individual (1) has personal liability (as defined in 301.7701-3(b)(2)(ii) of the Procedure and Administration Regulations) for the debts of or claims against the partnership by reason of being a partner; (2) has authority to contract on behalf of the partnership under the statute or law pursuant to which the partnership is organized; or, (3) participates in the partnership's trade or business for more than 500 hours during the taxable year. If, however, substantially all of the activities of a partnership involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting, any individual who provides services as part of that trade or business will not be considered a limited partner.
Exclusion of any of these is possible in an
LLC agreement.
It is also possible to create payments not defined as self-employment income if they come as repayments of loans or other guaranteed payments. If an investor made a loan to the organization based on, e.g., proceeds of individually obtained second mortgages on residential or other real estate an investor owns, the returns on such capital would not be taxed as self-employment income.
Corporation
So long as the organization, and not the individual, is the fee or income receiving organization, a Subchapter C corporation distribution of dividends does not create self-employment tax obligations. This would, however, subject your earnings to organization level tax.
A Subchapter S corporation election would permit avoidance of employment tax on distributions. These are treated as dividends under Internal Revenue Code Section 1368, unless the payment to a shareholder is a tax-free distribution which would reduce the shareholder's basis in the organization, or a distribution which exceeds the organization's earnings and profits. Subchapter S corporations are taxed on a pass-through basis on all earnings, whether or not these are distributed to shareholders.
Some states, like Illinois, Texas, and Delaware, have franchise taxes based on organizational capitalization, rather than on income, and these may argue for use of a Limited Liability Company instead of a Subchapter S corporation, if capitalization is large enough, and distributions from the LLC would be able to be structured to meet the tests (less than 500 hours participation, return of capital, no agency authority, etc ...) needed for limited partner status.
To use a corporation organized in or operating in Illinois as an example, a Subchapter S corporation would pay Illinois franchise taxes, to the extent that earnings are retained as organizational capital. The rate is 1/10th of 1% of the "paid-in capital," which is the sum of stated capital plus paid-in surplus of income over expenses for the organization. The maximum franchise tax is $1 million, the minimum $25. For a retained earnings amount of $50,000, the annual franchise tax would be $50.
Limited partnership
An organizer of a limited partnership is able to structure compensation as either subject to or not subject to self-employment tax. This is done by creating a general partnership interest (subject to the minimum capitalization tests for same, and other tests under section 704 of the Internal Revenue Code), and a limited partnership interest, held by the same person (usually an incorporated general partner, to limit individual liability). The relative percentage in each would, for an individual, determine what percentage was subject to self-employment tax. The general partnership percentage of revenue (based on percentage of ownership by the general partnership) would be, the limited partnership percentage would not.
Current proposals for change
The section council, section of Federal Tax, has released an AICPA and ABA Federal Tax Section legislative proposal for comment by other ISBA sections which would specify that, for all organizations taxed as partnerships,