S Corporations as Shareholders, LLC Members, and Partners

I. Introduction

In contrast to the double tax regime applicable to C corporations (in which income is taxed at the corporate level and then taxed again when distributed to shareholders), the income of qualified electing S corporations generally is taxed only at the shareholder level on a passthrough basis. Over the more than six decades that have passed since subchapter S was added to the Internal Revenue Code,¹ the tax landscape for closely held entities has undergone many significant changes. It has been influenced especially by:

• the vacillating differential between individual and corporate rates, with the corporate rate now at a historic low of 21 percent (against a current top individual rate of 37 percent)² and qualified dividends taxed to noncorporate shareholders (since 2003) at the same rate as long-term capital gains (currently 20 percent);³

• repeal in the mid-1980s of the General Utilities doctrine, thus requiring corporate-level taxation on distributions of appreciated property to shareholders;⁴ and

• the emergence in the 1990s of (1) single-member limited liability companies (SMLLCs) treated as disregarded entities for tax purposes and (2) so-called check-the-box corporations, including sole proprietorships, partnerships, LLCs, and other unincorporated entities that may be treated as corporations for tax purposes.⁵

Subchapter S has also seen many important changes over the years, including:

• periodic increases in the number of permitted S corporation shareholders (originally 10, now 100);

• S corporations (since 1996) being allowed to hold any percentage stock interest in a C corporation and to elect so-called qualified subchapter S subsidiary/disregarded entity treatment for wholly owned domestic corporate subsidiaries (QSubs);⁶

• the government (since 1982) being allowed to impose corporate-level tax on S corporations for certain built-in gains (BIGs) and passive income (sections 1374 and 1375);⁷

• a reduction, from 10 years to five years, in the period over which BIG assets must be held to avoid corporate-level tax upon their disposition;⁸ and

• the enactment (in 2017) of section 199A as part of the Tax Cuts and Jobs Act, providing a deduction to S corporation shareholders of up to 20 percent of qualified business income derived from S corporations.⁹

S corporations continue to be quite popular, although the critical choice-of-entity analysis (that is, C corporation versus S corporation versus partnership/LLC) can be more complicated in some cases in light of the TCJA’s reduction of the corporate tax rate (from 35 percent to 21 percent) and the overlay of new section 199A.¹⁰ There are no limitations on the size of S corporations (that is, total asset value) or on the number or (with some narrow exceptions) types of businesses that an S corporation can conduct.¹¹ While the activities of many S corporations relate exclusively to the direct conduct of a single business through a single corporation, it is also common for S corporations to engage in multiple businesses and to serve as the parent entity of a group that includes direct or indirect ownership interests in C corporations, QSubs, partnerships and single- or multimember LLCs. The choice-of-entity analysis for S corporations often extends as well to selecting the appropriate tax status for entities affiliated with the S corporation.¹²

This two-part report explores various scenarios and interactions involving S corporations and their affiliated entities. This first installment outlines the fundamentals of how subchapter S operates and begins an examination of numerous scenarios, with particular focus on the federal income tax treatment of transactions through which the S corporation comes into existence, other entities become affiliated with the S corporation group, and cash or other property is transferred from an affiliate to the S corporation or between affiliates. Part 2 will examine scenarios in which a complete or partial interest in an affiliate is sold or otherwise disposed of by the S corporation, including through a taxable stock or assets transaction, a tax-free reorganization under section 368, or a tax-free corporate separation under section 355.

II. Subchapter S Fundamentals

A. Electivity and Qualification Requirements

S corporation status is elective, through the filing of IRS Form 2553, “Election by a Small Business Corporation.” The timing of the election differs depending on whether the corporation is being formed as an S corporation from its inception or is an existing C corporation that is converting to an S corporation.¹³ All existing — and in some circumstances prior — shareholders must consent to the election, but no consent is required of persons who become shareholders after the election.¹⁴ A corporation can qualify for S status if it (1) is a domestic corporation; (2) has only one class of outstanding stock (all shares of which carry identical rights to corporate distributions); and (3) has no more than 100 eligible shareholders,¹⁵ including individuals who are U.S citizens or resident aliens, decedents, bankruptcy estates, and some types of trusts and exempt organizations. Other corporations (C or S, domestic or foreign) cannot own stock in an S corporation, nor can partnerships or multimember LLCs. However, stock owned by an SMLLC of an eligible individual will be treated as owned by the individual and will not disqualify the corporation from obtaining S status.¹⁶ Moreover, although an S corporation cannot own stock in another S corporation (because the subsidiary would have an impermissible corporate shareholder), it can make a QSub election for another wholly owned domestic corporation and thereby treat that subsidiary as a disregarded entity for tax purposes.¹⁷

B. Passthrough Taxation Regime

S corporations are not subject to corporate-level taxation (at 21 percent or any other rate), except in limited circumstances involving BIGs (taxed to the S corporation under section 1374) or specific types and levels of passive income (taxed under section 1375). Instead, items of income, deduction, loss, and credit generated by the S corporation (calculated under rules and conventions applicable to individual taxpayers) pass through pro rata to the shareholders under section 1366, generally with the same character (for example, operating income, dividend income, or capital gains). The passthrough items are reported on the shareholder’s individual return and are combined with like items generated by the shareholder outside the S corporation (including from ownership interests in other S corporations, C corporations, or partnerships). Passthrough income is taxable to the shareholders when generated, whether or not distributed. Operating and capital losses also pass through pro rata to the shareholders, but only to the extent of the shareholder’s basis in the stock of the corporation and any loans that the shareholder may have made to the corporation.¹⁸ If the pro rata amount of losses exceeds the available stock and debt basis, the excess becomes a suspended loss, which is available to the shareholder if and when additional basis arises (for example, as a result of future income or capital contributions).¹⁹ Unlike the generally static basis of stock in a C corporation (that is, the amount originally paid for the stock), the basis of S corporation stock is adjusted on an ongoing basis under the rules of section 1367 — upward for passthrough income and gains, and downward (but not below zero) for shareholder distributions and passthrough losses.

C. Distributions to Shareholders

Stock basis is also critical in determining the tax treatment of distributions by S corporations to shareholders. S corporations normally do not have earnings and profits, which C corporations must have to support dividend taxation of distributions to shareholders (under sections 301, 312, and 316). Instead, under section 1368, S corporation distributions of amounts previously taxed when the underlying earnings were generated reduce stock basis, and any distributions in excess of stock basis are taxed as capital gain (that is, as if the stock were sold). Some S corporations may have accumulated E&P relating to years in which they were C corporations or inherited from C corporations in tax-free mergers with related or unrelated C corporations or liquidations of controlled subsidiaries. Distributions by those S corporations are treated as taxable dividends out of the accumulated E&P only to the extent that they exceed the corporation’s accumulated adjustments account (AAA). The AAA essentially represents a running account designed to reflect the corporation’s previously taxed income and computed in close congruity with the stock basis adjustments required by section 1367. In some instances, shareholders may elect to avoid the protection of the AAA and instead treat distributions as taxable dividends paid out of accumulated E&P.²⁰

D. Interface Between Subchapters S and C

Section 1371(a) provides that unless a provision of subchapter S expressly dictates otherwise, the rules of subchapter C applicable to C corporations (sections 301 et seq.) will also govern the tax treatment of transactions between S corporations and their shareholders and outside parties. Thus, if individuals transfer appreciated property into an S corporation, or if an S corporation transfers appreciated property into a newly formed, wholly owned subsidiary corporation, the transfer will be accorded nonrecognition treatment under section 351 and will be governed by related basis (sections 358 and 362) and liability assumption (section 357) provisions. Likewise, S corporations and their shareholders can engage in redemption transactions governed by section 302; liquidations (taxable under sections 331 and 336 or tax free under sections 332 and 337); mergers and other types of tax-free reorganization transactions (under section 368); and spinoffs or other types of tax-free separations (under section 355).²¹ However, dividend-type distributions by S corporations generally are nontaxable under the rules of section 1368 to the extent of the AAA balance (as opposed to being treated as section 301 distributions). And importantly, S corporations do not escape the reach of General Utilities repeal, for distributions of appreciated property to S corporation shareholders (liquidating or nonliquidating) trigger taxable corporate-level gain that passes through to the shareholders (under sections 311(b) and 336(a)).²²

III. S Corporation Affiliates

A. C Corporations and QSubs

As noted earlier, S corporations can own any amount of stock in a C corporation, including a small portfolio interest, a controlling or substantial minority interest in a publicly traded company, or a controlling interest in a closely held subsidiary. An S corporation can also own a “stock” interest in a noncorporate entity for which a check-the-box election has been made. If the S corporation owns 100 percent of the stock of a domestic subsidiary (including a check-the-box entity), it can make a QSub election for that corporation.²³ As a result of that election, the QSub will become a disregarded entity, and all its income, outlays, assets, and liabilities will be treated for tax purposes as earned, expended, owned, and incurred by the S corporation parent, as if the QSub did not exist. In effect, the QSub is part of an S corporation for tax purposes but remains a separate corporate entity for all nontax purposes.

If a QSub election is not or cannot be made and the S corporation owns stock of a C corporation, the C corporation files a separate Form 1120 return, and any dividends it pays to the S corporation will pass through as dividend income to the shareholders. A C corporation affiliate and lower-tier subsidiaries that meet the statutory affiliation requirements of section 1504(a)(2) (80 percent of vote and value) can elect to file a consolidated return for federal income tax purposes, but the S corporation parent is not eligible to join the consolidated return group.²⁴

Cases 1 through 7 below address the tax ramifications of various transactions between S corporations and corporate affiliates.

Case 1. C corporation dividends.

Esco, an S corporation since its inception, has two shareholders: Jim (75 percent) and John (25 percent). It directly conducts an active business (Business 1), holds small stock interests in several publicly traded companies, and owns a 20 percent stock interest in Opco, a C corporation that conducts a different active business (Business 2). Two unrelated individuals each own 40 percent of the Opco stock. In 2021 Esco receives dividends on its publicly held stocks (portfolio dividends) aggregating $10,000. Opco has current E&P for 2021 of $500,000 and distributes $100,000 to Esco and $200,000 to each of the other two Opco shareholders.

Neither the portfolio dividends nor the Opco dividends are taxable to Esco, but rather pass through pro rata to Jim and John. As such, they retain their character as dividend income and are taxed to Jim and John on their personal returns (at the 20 percent qualified dividend rate plus the 3.8 percent surtax on net investment income). Under the passthrough regime, Jim and John are taxed on the dividend income received by Esco, and their Esco stock basis is correspondingly increased (under section 1367(a)(1)), regardless of whether that income (or any other income) is distributed by Esco. If Esco were a C corporation, the portfolio dividends would carry an intercorporate dividends received deduction (DRD) of $5,000 (50 percent) for the portfolio dividends and $65,000 (65 percent) for the Opco dividend.²⁵ As individual shareholders of an S corporation, however, Jim and John are not entitled to claim any DRD for passthrough dividend income. The same consequences would hold if Esco owned any other percentage stock interest in Opco less than 100 percent.

All the dividend income received by Esco would constitute passive investment income for purposes of section 1375. That provision could come into play only if (1) Esco had any accumulated E&P at the close of the tax year and (2) more than 25 percent of its total gross receipts were attributable to dividends or other sources of passive investment income (as defined in section 1362(d)(3)). So if Esco had any accumulated E&P from a prior transaction with a C corporation and had gross receipts of $190,000 from Business 1, its dividend income ($110,000) would exceed $75,000 (the 25 percent threshold — that is, $300,000 * 25 percent), and thus trigger a corporate-level tax to Esco on the $35,000 excess amount of passive income.²⁶ However, if Esco instead owned at least 80 percent of the Opco stock (in terms of vote and value), any dividend received from Opco (and attributable to an active trade or business of Opco) would not constitute tainted passive investment income for purposes of section 1375.²⁷

Case 2. QSub election.

Assume that Esco instead owns all the outstanding stock of Opco, for which a valid QSub election is in effect. In 2021 Opco generates $300,000 of taxable income from Business 2 operations and distributes $150,000 to Esco. Esco’s 2021 taxable income is $550,000, including $500,000 from Business 1 operations and $50,000 from portfolio dividends and capital gains. In early 2021 Esco transferred to Opco a parcel of vacant land having a fair market value of $100,000 and a basis of $50,000. The land was encumbered by a $75,000 bank loan, which was assumed by Opco. No additional Opco shares were issued to Esco in exchange for the land.

Because the QSub election rendered Opco a disregarded entity, its taxable income is treated as taxable income of Esco, and Opco’s distribution to Esco is ignored for tax purposes — that is, it is treated as if Opco did not exist and Esco had instead transferred the distributed funds to itself out of its own assets.²⁸ Thus, the combined operating income of Esco and Opco is $800,000, which passes through pro rata to Jim ($600,000) and John ($200,000) and is taxed to them at their ordinary income rate (37 percent maximum). The passthrough dividend income of $50,000 also passes through pro rata to Jim and John (taxed at 20 percent) and, as in Case 1, no DRD is available. The passthrough capital gains are combined with/offset against any other capital gains or losses that Jim or John might otherwise have, with any resulting net capital gain being taxed at 20 percent. The dividends and capital gains also trigger the 3.8 percent surtax on NII (under section 1411). If Jim or John do not materially participate in the business activities of Esco or Opco, they also are liable for the surtax on their pro rata share of the passthrough operating income because it would be considered passive income to them.²⁹

As an S corporation, Esco incurs no corporate-level tax on income generated by Esco or Opco. Jim’s and John’s bases in their Esco stock is increased by the passthrough operating and investment income (under section 1367(a)(1)) and decreased by any shareholder distributions made by Esco in 2021 (under section 1367(a)(2)).

Nor is any taxable income generated by Esco’s transfer of the land to Opco. If Opco were a C corporation, the transfer would trigger a section 357(c) gain to Esco of $25,000 (that is, the excess of assumed liability over the land basis), which would pass through as taxable income pro rata to Jim and John and correspondingly increase the basis of their Esco stock (and decrease stock basis by the amount of the assumed liability).³⁰ However, because Opco is a QSub, the transfer is disregarded for tax purposes.

Case 3. Corporate affiliate with NOL.

Assume that the Esco stock is instead owned 50-50 by Jim and John and that Opco’s sole class of outstanding stock is 75 percent owned by Esco. An unrelated party, U, owns the remaining 25 percent Opco stock interest. In 2021 Opco has a net operating loss of $300,000 and makes no distribution to Esco, and Esco has operating income of $250,000 and distributes $100,000 to each of Jim and John. At the beginning of 2021, Jim and John each had a basis of $50,000 in their Esco stock.

Because Opco is a C corporation ineligible for a QSub election (because it is not wholly owned by an S corporation), no portion of its 2021 loss is usable by Esco. Rather, the loss is usable only against Opco’s later-generated taxable income, subject to the loss carryover rules of section 172 as amended by the TCJA and subsequent legislation.³¹ Esco’s basis in its Opco stock is not affected by the Opco loss. Esco’s 2021 operating income ($250,000) passes through pro rata to Jim and John and increases their respective stock bases in Esco by $125,000 to $175,000. The $100,000 distributions to each are nontaxable and reduced their Esco stock basis to $75,000.³²

If Opco was wholly owned by Esco with a valid QSub election in effect, its NOL would be considered Esco’s loss, giving Esco a combined NOL of $50,000 ($250,000 operating income less $300,000 NOL). That loss would pass through pro rata to Jim and John to the extent of their respective Esco stock bases (determined before any distributions),³³ so there would be ample stock basis ($50,000 increased by $125,000 allocable share of income, or $175,000) to absorb the full loss. If either had a stock or shareholder debt basis that was less than their pro rata share of the loss, the difference would be considered a suspended loss of that shareholder, triggered (that is, passed through) only when his stock (or shareholder debt) basis increased enough to absorb the suspended loss.³⁴ Any passthrough loss reduces shareholder stock basis (but not below zero), even if the loss is not actually used by the shareholder on his personal return (because he has no, or not enough, personal taxable income against which the loss could be offset).

Case 4. Corporate affiliated group.

Assume that Esco owns all the Opco stock and that a valid QSub election is in effect for Opco. Effective January 1, 2021, Opco purchases all the outstanding stock of Corp. X, which conducts Business 3. X also owns all the outstanding stock of Corp. Y and Corp. Z, which conduct Business 3 in different states. X, Y, and Z have previously filed a consolidated corporate federal income tax return. In 2021 (1) Esco has an operating loss of $200,000; (2) Opco has operating income of $700,000; (3) X has an operating loss of $300,000; (4) Y has operating income of $600,000; (5) Z has an operating loss of $200,000; (6) Y distributes $400,000 to X; (7) X distributes $100,000 to Opco; (8) Opco distributes $500,000 to Esco; and (9) Esco distributes $200,000 to each of Jim and John. Also in 2021, X transfers to Y a parcel of vacant land with a value of $100,000, a basis of $50,000, and a $75,000 outstanding mortgage liability (assumed by Y).

On these facts, Esco could make a QSub election for each of X, Y, and Z. If Opco, X, Y, and Z were all QSubs, their 2021 operating income or loss would be combined and treated as if earned or incurred directly by Esco. The distributions from Y to X, X to Opco, and Opco to Esco would all be disregarded for tax purposes and treated as if Esco made the distributions to itself. Thus, Esco would have net operating income of $600,000 for passthrough purposes,³⁵ which would be fully taxable to Jim and John even though only $400,000 was actually distributed. The net aggregate effect on their Esco stock bases would be a $200,000 increase — that is, $600,000 (passthrough income) less $400,000 (distribution). The transfer of the land by X to Y, both QSubs, would be disregarded and thus would not trigger a section 357(c) gain (or any concomitant stock basis increase) for the excess liabilities.

Instead of a three-tier structure under Esco (that is, Opco, X, and Y/Z), Opco could change to a two-tier structure (that is, Opco and X/Y/Z) by having X distribute the Y and Z stock upstream to Opco. Again, these stock distributions between existing QSubs would be disregarded for tax purposes. The QSub status of Opco, X, Y, and Z would not be disturbed because all would remain wholly owned for tax purposes by an S corporation (Esco).³⁶

If a QSub election is not made for Opco, the Opco corporate group could file a consolidated return (with Opco as common parent and X, Y, and Z as members). As an S corporation, Esco could not be a member of the consolidated group. The Opco group’s combined net taxable income would be $800,000,³⁷ and the $500,000 Opco distribution to Esco would constitute dividend income (assuming sufficient E&P) that would (1) separately pass through pro rata to Jim and John, (2) not be eligible for a DRD, and (3) not be considered tainted passive income for section 1375 purposes.³⁸ The Esco operating loss of $200,000 would also pass through pro rata to Jim and John (assuming sufficient stock basis). Esco’s basis in the Opco stock would not be affected. However, Opco’s basis in the X stock, and X’s basis in the Y and Z stock, would be adjusted under the consolidated return regulations (upward for income and downward for distributions and losses).³⁹

The intragroup cash distributions (from Y to X, and from X to Opco) would be eliminated from the distributee corporation’s income (the equivalent of a 100 percent DRD) and reduce the distributee’s stock basis in the distributing affiliate.⁴⁰ If X were to distribute the Y and Z stock to Opco to eliminate a structural tier, the distributions should qualify for nonrecognition treatment as internal section 355 spinoffs, even though the X stock had been acquired in a taxable transaction during the five-year period preceding the distribution.⁴¹ Absent the protection of section 355, the value of the distributed stock would still be eliminated from consolidated income, but any excess of the then-value of the distributed stock over X’s basis in that stock would constitute a taxable gain under section 311(b). That gain, however, would be treated as a deferred intercompany gain and generally would not be triggered as long as the Y and Z stock remained in the Opco group.⁴²

X’s transfer of the land to Y would not trigger a section 357(c) gain because that provision does not apply to transfers within a consolidated return group.⁴³ As a result, the transfer would be accorded nonrecognition treatment under section 351, but the assumed liability would reduce Opco’s stock basis in the X stock (under section 358(d)).

Case 5. Corporate affiliated group with outside shareholder.

The facts are the same as in Case 4, except that (1) Esco owns 90 percent of the Opco stock (and U owns 10 percent); (2) X owns all the Z voting common stock; and (3) U owns all the Z nonvoting preferred stock, which represents 30 percent of Z’s total value.

Esco cannot make a QSub election for Opco because it does not own all the outstanding Opco stock. Thus, Opco is a C corporation and the parent company of a group of C corporations including X, Y, and Z. That group can file a consolidated return only if each member meets the dual 80 percent affiliation requirement of section 1504(a)(2) — that is, at least 80 percent of the voting power and value of the member’s stock must be directly owned by another member of the group. Here, Opco clearly meets this requirement for X, its wholly owned subsidiary. Likewise, X meets the requirement for Y, its wholly owned subsidiary. Whether X meets the affiliation requirement for Z depends on whether U’s interest in Z is considered plain vanilla preferred stock — that is, whether beyond being preferred and nonvoting, it satisfies all the other definitional elements of section 1504(a)(4).⁴⁴ If it does, U’s preferred stock interest in Z is not considered stock in applying the 80 percent affiliation thresholds. X therefore would be treated as owning 100 percent of both the voting power and value of Z, thus qualifying Z as a member of the Opco consolidated return group.

If the Z preferred stock does not qualify as plain vanilla preferred, Z cannot be a member of the affiliated group because X owns less than 80 percent of Z’s total value. In that event, Opco, X, and Y would comprise the consolidated return group, and Z would file a separate corporate return. Any dividends paid by Z to X would carry only a 65 percent DRD (because the 100 percent DRD requires at least 80 percent ownership of vote and value).

Assume instead that X owned all the Z class A voting common stock, and U owned all the Z class B nonvoting common stock (worth 30 percent of Z’s total value). On these facts, the Z class B common would have to be taken into account for purposes of the 80 percent affiliation tests. Z cannot be a member of the Opco consolidated group because X owns less than 80 percent of the total value of the Z stock. However, a consolidated return can still be filed by Opco as common parent of a group including itself, X, and Y. That group would have combined taxable income of $1 million. As in Case 4, the $500,000 distribution by Opco to Esco would pass through as dividend income to Jim and John. Z would have to file a separate Form 1120 corporate income tax return. Its $200,000 NOL could not offset any income of the Opco/X/Y group but could be used against taxable income generated by Z in subsequent tax years. As a planning matter, it might be possible to include Z as a member of the Opco group through a tax-free recapitalization transaction (under section 368(a)(1)(E)) that increases X’s percentage of total value to at least 80 percent.⁴⁵

Case 6. Conversion of C affiliated group to S affiliated group.

The outstanding stock of Opco, a C corporation, has for many years been owned 40 percent by each of Jim and John and 20 percent by XYZ LLC, a multimember LLC. Opco conducts Business 1. Opco’s wholly owned subsidiary, Subco, conducts Business 2. In late 2020 Opco redeems the entire XYZ stock interest for cash. On February 15, 2021, it files valid elections to be classified as an S corporation and for Subco to be classified as a QSub, both effective January 1, 2021. On that date, Opco’s Business 1 assets are worth $2 million and have an aggregate basis of $1 million, and Subco’s Business 2 assets are worth $1.5 million and have an aggregate basis of $750,000. Opco and Subco have previously filed a consolidated return. On December 31, 2020, Opco’s basis in the Subco stock is $500,000, and Opco and Subco have accumulated E&P of $300,000 and $200,000, respectively.

The redemption of the XYZ stock leaves Opco with remaining shareholders (Jim and John) who are eligible S corporation shareholders. After electing S corporation status, Opco could not continue to file a consolidated return with Subco, but it permissibly made a simultaneous QSub election for wholly owned Subco (instead of leaving Subco as a separately taxable C corporation). The conversion of Opco (an existing C corporation) to an S corporation is a nontaxable event and does not trigger any deemed transaction(s) for federal income tax purposes. The QSub election for Subco, however, triggers a deemed tax-free section 332 liquidation of Subco into Opco and the concomitant inheritance by Opco (under section 381(a)) of Subco’s accumulated E&P and assets having net unrealized built-in gains (NUBIG) of $750,000 (under section 1374(d)(8)).⁴⁶ Combined with Opco’s NUBIG of $1 million,⁴⁷ Opco will start its S corporation existence with substantial BIG assets that, if sold or otherwise disposed of in a taxable transaction during the ensuing five-year period, will trigger corporate-level tax to Opco (even though it is an S corporation) under section 1374.

Opco’s inheritance of combined accumulated E&P of $500,000 from the Opco and Subco C corporation years may have tax relevance in two respects. First, in any tax year that Opco (and its disregarded entity, Subco) continues to have any accumulated E&P and generates an impermissible level of specific types of passive income (generally more than 25 percent of gross receipts), it will be subject to a corporate-level tax on that income under section 1375, and it could lose its S status if it has accumulated E&P (even only $1) and tainted passive income for three consecutive tax years. Second, the existence of accumulated E&P will subject Opco to the section 1368 AAA tax regime and could cause some distributions to be treated as taxable dividends paid out of accumulated E&P.⁴⁸

If Opco were to have an NOL at the end of 2020, that loss could be used by Opco during the applicable five-year period to offset any recognized BIGs, thus reducing or possibly eliminating the section 1374 corporate-level tax that otherwise would result.⁴⁹ The existence of an NOL, however, might cause Opco to forestall an S election in anticipation of subsequent taxable income against which the NOL could be offset on a C corporation return.

Case 7. Foreign subsidiary.

Esco, an S corporation with shareholders Jim (75 percent) and John (25 percent), directly conducts Business A in the United States and owns all the stock of a foreign corporation (FC). In 2020 FC (1) earns $100,000 of income properly characterized as subpart F income; (2) earns $50,000 of income properly characterized as effectively connected with Business A; and (3) distributes $100,000 to Esco.

FC’s effectively connected income is taxable by the United States under section 882(a) at the regular 21 percent corporate rate, notwithstanding any applicable treaty provision. FC’s actual distribution to Esco is dividend income that passes through pro rata to Jim and John without any DRD (which, under new section 245A, could be available only to C corporation recipients).⁵⁰ John and Jim also have taxable income under section 951(a) on their respective pro rata shares of FC’s subpart F income ($75,000 and $25,000), which is triggered because FC is a controlled foreign corporation under section 957(a) (more than 50 percent owned by U.S. shareholders who own 10 percent or more of the foreign corporation’s stock). Esco, Jim, and John are considered U.S. shareholders of FC under section 958(b) and the stock attribution rules of section 318(a)(2)(A) and(5)(E).

The subpart F income that passes through to Jim and John is not characterized as a dividend, and therefore is taxed at their ordinary individual rates (that is, not the 20 percent qualified dividend rate). Subpart F income can nonetheless constitute tainted passive income for section 1375 purposes to the extent not attributable to FC’s active business earnings.⁵¹

FC’s distribution to Esco would not generate a deemed foreign tax credit (under section 960(a)) unless Jim and John made a special election (under section 962) to be treated as corporations (rather than individuals) for the FC earnings giving rise to their respective subpart F inclusions. In that event, they would pay tax on the inclusion amount at the 21 percent corporate rate and receive an FTC for foreign taxes paid by FC on the subpart F earnings.⁵²

These results would hold under current rules regardless of the respective ownership interests of Jim and John in Esco. However, under regulations proposed in 2019 under section 958,⁵³ if Jim instead owned less than 10 percent of Esco (and John owned 91 percent), Jim would have no subpart F income inclusion from FC (while John would have to include $91,000).

Different tax consequences would also result if, instead of Esco owning the FC stock directly, a wholly owned U.S. C corporation subsidiary of Esco (Sub) owned the FC stock, and the FC dividend was paid to Sub. In those circumstances, Sub could claim a 100 percent DRD under section 245A (added by the TCJA) on the foreign-source portion of FC’s undistributed earnings not attributable to ECI.⁵⁴ The FC dividend to Sub would not trigger any taxable income to John or Jim. However, Sub would receive a deemed paid FTC (under section 960(a)) for the foreign income taxes paid by FC on the earnings that gave rise to the subpart F inclusion.

B. LLCs and Partnerships

In addition to holding stock interests in other corporate entities, an S corporation can own any level of equity interests in LLCs or partnerships. LLCs are noncorporate state law entities owned by one or more members. Like corporations, LLCs generally protect all the members from personal liability for third-party claims in connection with LLC operations and activities. There generally are no limitations regarding who can be a member (including non-individuals), the number of members, or the types or value of assets held by the LLC. For federal income tax purposes, an SMLLC is treated as a disregarded entity unless a check-the-box election is made by the member-owner to treat the SMLLC as an association taxable as a corporation under subchapter C.⁵⁵ If the single member is an individual or other eligible S corporation shareholder, an election can also be made to treat the check-the-box SMLLC as an S corporation.⁵⁶ A multimember LLC is normally considered a partnership for tax purposes (subject to the passthrough and other rules of subchapter K) but can instead be treated as a corporation under a check-the-box election.⁵⁷ A check-the-box multimember LLC or partnership can also be an S corporation if all the members/partners are eligible shareholders and have identical rights to current and liquidating distributions.⁵⁸

Partnerships are also state law entities. They differ from multimember LLCs principally on personal liability of the partners. General partners are liable for all third-party claims against the partnership, whereas limited partners are generally responsible only to the extent of their investment in the partnership. There are various forms of limited liability state law partnerships, including, for example, limited partnerships, limited liability partnerships, and limited liability limited partnerships. All these entities are governed for federal income tax purposes by subchapter K of the code, unless subject to a check-the-box election.

Cases 8-14, below, explore various scenarios involving S corporation ownership of LLC and partnership interests.

Case 8. First-tier SMLLCs.

The stock of Esco, an S corporation, is owned 50-50 by Jim and John. Esco directly owns and operates a rental apartment project (Building A) and also owns and operates two similar projects (Building B and Building C) indirectly through SMLLC 1 and SMLLC 2. In 2021 (1) Esco had a net loss of $300,000 on the rental operations of Building A; (2) SMLLC 1 had net income of $400,000 from Building B operations; and (3) SMLLC 2 had net income of $200,000 from Building C operations. On September 1, 2021, SMLLC 2 sold Building C to an unrelated buyer for an all-cash purchase price of $1 million. Building C had originally been transferred by Esco to SMLLC 2 in 2015, at which time it had a value of $750,000 and an adjusted basis of $500,000. After the transfer, SMLLC 2 made capital improvements of $100,000 and claimed depreciation deductions of $100,000 for Building C. At the end of 2021, SMLLC 1 distributed $150,000 to Esco, and Esco distributed $600,000 to each of Jim and John. Esco had no accumulated E&P at the end of 2021.

The tax ramifications of this structure are the same as if SMLLCs 1 and 2 were instead QSubs. Absent a check-the-box election, SMLLCs of an S corporation are classified as disregarded entities for tax purposes, so that all income, gains, losses, deductions, and credits of SMLLCs 1 and 2 are treated as occurring at the Esco level.⁵⁹ That would also be the case if Building B and Building C were owned and operated through wholly owned corporate subsidiaries for which valid QSub elections had been made. As a result, taking into account the performance of SMLLCs 1 and 2, Esco would have combined operating income of $300,000 for passthrough purposes.⁶⁰

Further, SMLLC 2’s sale of Building C would be treated as having been made by Esco and would give rise to a gain of $500,000 — $1 million selling price less $500,000 basis in Esco’s hands (adjusted for post-2015 capital improvements and depreciation).⁶¹ That gain would pass through pro rata to Jim and John as a section 1231 long-term capital gain (along with any part of that gain representing ordinary income depreciation recapture) and would be combined with/netted against any other section 1231 gains or losses that Jim or John might have derived apart from Esco.⁶² The passthrough income and gain would increase their respective Esco stock bases by $400,000⁶³ and reduce that basis by the $600,000 distribution received by each. The $150,000 distribution by SMLLC 1 to Esco would be disregarded for tax purposes (as if made by Esco to itself) and therefore would not trigger any passthrough consequences to Jim or John.

Case 9. Conversion of C corporation to SMLLC.

Assume that Building B was instead owned and operated by a wholly owned C corporation subsidiary of Esco (Beeco). Esco decides to convert Beeco into an SMLLC under a state law statutory conversion procedure. A check-the-box election is not made for the new SMLLC. At the time of the conversion, Building B was worth $1 million and had an adjusted basis of $450,000.

For tax purposes, the conversion is treated as if Beeco completely liquidated into Esco tax free under section 332, followed by a deemed transfer of the liquidated Beeco assets/liabilities by Esco to the SMLLC.⁶⁴ Because the SMLLC is a disregarded entity (no check-the-box election was made), the deemed downstream transfer is a non-event for tax purposes (as if Esco had transferred the former Beeco assets/liabilities to itself).⁶⁵ Under sections 332 and 337, no gain or loss is recognized by Esco or Beeco on the deemed liquidating distribution, and the basis of Building B is transferred to Esco (under section 334(b)(1)). However, because Building B was acquired from a C corporation in a carryover basis nonrecognition transaction and has an appreciated value that exceeds its basis, it is considered a section 1374 BIG asset.⁶⁶ As a result, if Esco sells or otherwise disposes of Building B in a taxable transaction during the five-year period after its acquisition from Beeco, the gain on the transaction will be recognized and taxed at the corporate level to the extent of the BIG at the time of the conversion ($550,000), and the full gain on the disposition, less the amount of corporate-level tax, will pass through to the Esco shareholders.⁶⁷

Case 10. Conversion of SMLLC to QSub.

Effective January 1, 2022, Esco makes a valid check-the-box election for SMLLC 1, followed immediately by a valid QSub election. At that time, Building B is worth $1.2 million, has an adjusted basis of $400,000, and is subject to an outstanding mortgage liability of $500,000.

For state law purposes, the conversion requires an upstream transfer of the SMLLC 1 assets and liabilities to Esco, followed by a downstream transfer of those assets and liabilities by Esco to a newly formed corporation. For tax purposes, the upstream transfer is a non-event because SMLLC 1 is a disregarded entity — that is, the SMLLC 1 assets and liabilities are already treated as belonging to Esco. The check-the-box election for SMLLC 1 technically involves a deemed transfer of Building B and the mortgage liability to a new C corporation (Newco), which has only a transitory existence because it immediately becomes a QSub. If the momentary C corporation status of Newco is respected for tax purposes, the deemed transfer to Newco would be a section 351 nonrecognition transaction⁶⁸ but would trigger a taxable $100,000 section 357(c) gain (for the excess liabilities over basis) that passes through to Jim and John. The QSub election would then be treated as a tax-free liquidation of Newco, a C corporation, into Esco under sections 332 and 337. When the smoke clears, Esco would continue to own Building B through SMLLC 1, now a QSub.

Another way to look at this, however, is that the conversion of one disregarded entity into another disregarded entity of the same owner (for example, an Esco SMLLC into an Esco QSub, or vice versa) should be considered a nontaxable event, with the momentary C corporation status of Newco disregarded. This result can be reached by applying step transaction principles to treat the overall transaction as a tax-free reorganization of Esco under section 368(a)(1)(F) (a type F reorganization), which accords nonrecognition treatment to “a mere change in identity, form, or place of organization of one corporation, however effected.” A 2008 published ruling adopts this analysis,⁶⁹ and subsequent private letter rulings follow suit.⁷⁰

Case 11. Conversion of QSub to SMLLC.

Assume that Building B is instead owned and operated through an Esco QSub, which Esco decides to convert into a newly formed SMLLC. A check-the-box election is not made for the SMLLC.

For state law purposes, the conversion contemplates an upstream transfer of the QSub assets/liabilities to Esco and a retransfer of those assets into the newly formed SMLLC. Because Building B is already deemed owned for tax purposes by Esco (because QSub is a disregarded entity), the upstream transfer should be ignored as a transfer by Esco to itself. Likewise, the downstream transfer should be ignored because the SMLLC is automatically a disregarded entity of Esco (no check-the-box election having been made). The overall transaction should therefore be viewed on an integrated basis as a nontaxable conversion of one disregarded entity (QSub) into another (New SMLLC) — that is, as in Case 10, an F reorganization.⁷¹

If the termination of QSub status were instead viewed (under section 1361(b)(3)(C)(i)) as causing a deemed downstream section 351 transfer of Building B and the associated mortgage liability by Esco (the deemed holder of the QSub assets and liabilities) to a transitory C corporation (Newco), followed by an immediate section 332 liquidation of Newco back into Esco, section 357(c) gain and/or section 1374 BIG consequences could result. It seems unlikely, however, that the IRS would seek to assert that position.⁷²

Case 12. Partnership with ineligible S corporation shareholder.

Esco, an S corporation, has two equal shareholders, Jim and John. It conducts a very successful and rapidly expanding frozen pasta business (Business X) in need of additional capital. Victorio, an old friend of Jim’s who is an Italian citizen and resident, offers to invest $1 million cash in Business X in exchange for an equity position yielding a limited priority return. To preserve Esco’s S status, Esco and Victorio form a limited partnership (EscoLP) on January 1, 2021. Esco transfers the Business X assets and liabilities to EscoLP in exchange for 100 percent of the general partner interests and has full management and operational control over Business X. Victorio transfers $1 million cash to EscoLP in exchange for 100 percent of the limited partner interests, which carry formulaic limited priority entitlement to current and liquidating EscoLP distributions. At the time of the EscoLP formation, the transferred Business X assets are worth $5 million and have a basis of $2.5 million in Esco’s hands. The Business X liabilities assumed by EscoLP total $1 million. In 2021 (1) Business X generates operating income of $3 million, of which $2.8 million is allocated to Esco and $200,000 to Victorio; (2) EscoLP distributes $2 million to Esco and $200,000 to Victorio; and (3) Esco distributes $750,000 to each of Jim and John.

If Victorio were to become an Esco preferred shareholder, Esco would lose its S corporation status because he is not a U.S. citizen or resident and, further, because his equity interest would constitute a prohibited second class of stock. The limited partnership structure is designed to preserve Esco’s S corporation status. This end-run around the S corporation qualification requirements was originally challenged by the IRS but is now allowed by a 1994 published ruling⁷³ and an example in the subchapter K antiabuse rules.⁷⁴ The effect is to combine application of the partnership and subchapter S passthrough regimes within a single structure. An S corporation may hold a partnership or LLC interest as one of its assets or as its only asset, and unlike an S corporation, the partner/members of partnerships or LLCs need not have identical rights to distributions or allocations of profits and losses. Moreover, like an S corporation, partnership/LLC income or losses pass through to the partners whether or not distributed. Thus, in 2021 Esco would have $2.8 million of passthrough income from EscoLP and would in turn pass through $1.4 million of taxable income to each of Jim and John.

Esco’s transfer of Business X to EscoLP would not trigger any taxable gain to Esco under section 721(a), which accords nonrecognition treatment to transferors of appreciated property to a partnership (whether or not in exchange for a controlling partnership interest). As to basis consequences, under sections 722 and 752(a) and (b), Esco’s original basis in its EscoLP partnership interest would be $2.5 million ($2.5 million transferred asset basis less the $1 million liabilities assumed by EscoLP plus Esco’s $1 million share of EscoLP’s liabilities).⁷⁵ Under section 705(a), that amount would be increased to $5.3 million by Esco’s $2.8 million share of EscoLP’s 2021 income and then decreased to $3.3 million by the $2 million EscoLP distribution to Esco (not taxable under section 731(a)). Similar adjustments are required (under section 1367) with Jim’s and John’s basis in their Esco stock. Stock basis is increased by Esco’s share of the EscoLP income (and any other income generated directly by Esco) and decreased by the amounts of any EscoLP losses and any Esco distributions to Jim and John.

Case 13. Conversion of partnership to S corporation.

XYZ Partnership, a general partnership with three equal partners (Jim, John, and Bill), directly conducts a retail sports equipment business (Business X) and owns a real estate investment property through an SMLLC. Effective January 1, 2021, XYZ became an S corporation through a check-the-box election followed by an S election. On that date, the Business X assets had a value of $5 million and a basis of $2.5 million, and XYZ’s liabilities were $500,000. The investment property was unencumbered and had a value of $2 million and a basis of $1 million.

The partners/members of a partnership or multimember LLC who wish to continue as such for nontax legal purposes but be treated for tax purposes as an S corporation can (1) make a check-the-box election for the partnership/LLC (which thereby momentarily becomes a C corporation) and then (2) make an immediate S election for the check-the-box “corporation.”⁷⁶ In these circumstances, the Treasury regulations treat the check-the-box election as giving rise to a deemed downstream transfer of the partnership assets and liabilities into a newly formed corporation (Newco), followed by the partnership’s liquidating distribution of the Newco stock pro rata to the partners.⁷⁷ The S election for Newco is considered effective from Newco’s inception, so that Newco’s transitory existence as a C corporation is disregarded for tax purposes.⁷⁸ The end result is that the partnership goes out of existence for tax purposes, and the partners’ partnership interests are transformed into proportionate stock interests in an S corporation. The S election can be made only if all the partners would otherwise be considered eligible S corporation shareholders. Thus, an S election could not be made, for example, if one of the partners were a corporation or the former partners did not receive identical rights to current and liquidating distributions on their Newco stock.

If the deemed transfer to Newco of the XYZ assets and liabilities (including the investment property considered held through the SMLLC, a disregarded entity) qualifies for nonrecognition treatment under section 351, that treatment would result in (1) no gain to XYZ attributable to the appreciated value of the transferred assets or the assumption of liabilities (under section 357(a)); (2) a transferred basis of $3.5 million for Newco in the XYZ assets deemed transferred (under section 362(a)); and (3) a substituted basis of $3 million for XYZ in the Newco stock (under section 358(a) and(d)).

Section 351 qualification requires that the transferor (XYZ) have at least 80 percent control (section 368(c) control⁷⁹) of the transferee corporation (Newco) “immediately after the exchange.” While section 351(c) provides that a corporate transferor can distribute more than 20 percent of the transferee corporation stock to its shareholders without breaking the requisite section 368(c) control, XYZ is not a corporate transferor. XYZ’s subsequent deemed liquidating distribution of the Newco stock to the XYZ partners therefore would not have the technical protection of section 351(c) and might be considered to violate the “control immediately after” requirement on step transaction grounds. However, based on a 1984 published revenue ruling, the IRS will not assert violation of the section 351 “control immediately after” requirement in these circumstances, even though the deemed transactions are carried out under an overall plan.⁸⁰

The deemed liquidating distribution of the Newco stock to the XYZ partners will be nontaxable under section 731(a) because no money or marketable securities will be distributed. Nor, under section 731(b), will XYZ recognize gain attributable to the distributed Newco stock (which would have a value exceeding the basis obtained by XYZ in the deemed section 351 transaction). The former XYZ partners will take a basis in their Newco stock equal to the adjusted basis of their partnership interests (under section 732(b)).

As noted earlier, the partnership’s momentary ownership of Newco as a C corporation should be disregarded for S corporation qualification purposes because Newco is considered an S corporation from its inception. Thus, the appreciated assets received by Newco from XYZ should not be considered tainted BIG assets subject to potential corporate-level tax under section 1374 if sold during the five-year period following their transfer to Newco. Moreover, as an S corporation, Newco can continue to hold the investment property through a disregarded entity — that is, either an SMLLC or a QSub.

The incorporation of a partnership can also be implemented without a check-the-box election. In Rev. Rul. 84-111, 1984-2 C.B. 88 (which preceded adoption of the check-the-box rules), the IRS recognized three alternative transactional formats for accomplishing this.⁸¹ The first format (discussed above) is a section 351 transfer of the partnership assets to Newco followed by a section 731 liquidating distribution of the Newco stock to the partners. The second format involves a liquidating distribution of the partnership assets to the partners followed by a section 351 transfer of the distributed assets to Newco. The third format involves the partners forming a Newco and exchanging all their partnership interests (that is, “property”) for the Newco stock in a section 351 transaction, thus causing a termination of the partnership (which requires more than one partner).⁸² While all of these formats permit an immediate S election for Newco, each may spawn different collateral tax consequences (for example, regarding the basis, holding period, or character of any recognized gain or income). In deciding how best to incorporate a partnership, the partners need to consider which of the Rev. Rul. 84-111 formats is preferable in light of tax efficiency and feasibility from a nontax perspective.

Case 14. Conversion of S corporation to LLC.

Esco, an S corporation, owned 50-50 by John and Jim, conducts Business A directly and Business B through an SMLLC for which a check-the-box election has not been made. John and Jim form a new LLC (JJLLC) and, under a state law statutory merger procedure, (1) all of Esco’s assets and liabilities (including the assets and liabilities of the SMLLC) are transferred to JJLLC by operation of law; (2) Jim’s and John’s Esco stock is surrendered in exchange for JJLLC member interests; and (3) Esco ceases to exist. Under the merger, JJLLC acquires the sole member interest in the SMLLC, which continues to own and operate Business B. At the time of the merger, (1) Esco’s net asset value (including the SMLLC) was $4.5 million, representing gross asset value of $5.5 million and liabilities of $1 million; (2) the aggregate basis of the Esco/SMLLC assets was $3 million (some of which assets had a basis exceeding value); and (3) Jim and John each had a basis of $350,000 in their Esco stock.

This transaction will be treated as a complete liquidation of Esco, followed by a transfer of the former Esco assets/liabilities (including the sole member interest of the SMLLC) to JJLLC. The liquidation will be taxable to both the shareholders (under section 331(a)) and Esco (under section 336). The shareholder-level section 331 gain will be $3.8 million ($1.9 million each),⁸³ taxable as long-term capital gain at 20 percent plus the 3.8 percent section 1411 surtax. Further, the liquidating distribution will result in a section 336 corporate-level gain or loss, calculated on an asset-by-asset basis as if Esco had sold the distributed assets for their FMV.⁸⁴ Those gains and losses (subject to some limitations for losses) will pass through separately to Jim and John and be taxable to them as capital or ordinary gain or loss depending on the character of the distributed asset (for example, inventory, marketable securities, or section 1231 assets). In calculating the section 331 gain or loss, the shareholders’ Esco stock basis will be adjusted according to section 1367 for the section 336 gains (increased) and losses (decreased).

The deemed transfer of the liquidated assets by Jim and John to JJLLC in exchange for JJLLC member interests (50 percent each) will be a nontaxable transaction under section 721(a). JJLLC will take an FMV basis in the former Esco/SMLLC assets (that is, the basis acquired in the liquidation under section 334(a)). The SMLLC for Business B will remain in existence as a disregarded entity, now owned by JJLLC.

On the facts of Case 14, a conversion by an S corporation to a multimember LLC or partnership will likely be an expensive proposition taxwise and require close analysis of the interface between all relevant provisions of subchapters S, C, and K. A higher stock basis, as well as substantial loss assets in the corporation, could make the tax hit more palatable. But any desire for doing this type of transaction should in all events be dictated by strong nontax business reasons and the absence of a feasible, more tax-efficient alternative.