It's that time of the year again and my partner, Michael Cohen, and I are busy formulating the contents of the Thirteenth Annual Partnership, LLC & S Corporation Tax Planning Forums. Each year we are faced with the challenge of preparing and presenting all the new cutting-edge planning strategies. However, one topic that we continue to discuss and update on a regular basis is solving the problem of the S corporation that has C corporation earnings and profits ("C e&p") and "too much" passive investment income. This topic continues to earn a place on the program because we probably receive as many telephone calls from Forum attendees asking questions about this issue than on any other matter.
One might ask, however, what does this have to do with partnerships, the subject of this Partnership Tax Planning and Practice Guide? The answer--investing in a partnership is one of the solutions to the problem. Last year at the Forums, Michael and I passed on some "gossip," which reportedly emanated from the IRS, that the IRS was rethinking the solution that is the subject of this column. Apparently, it was only gossip, as last month the IRS issued PLR 199923007, which confirms the "partnership solution." Read on, as this month's Partner's Perspective discusses the whispering that apparently was at least temporarily laid to rest by the PLR.
There are two rules of which one must be aware when an S corporation has C e&p. Rule #1: To the extent that more than 25% of an S corporation's gross receipts constitute passive investment income (e.g., interest, dividends, rents from a "passive" rental business, royalties, gain from the sale or exchange of stock or securities) and the S corporation has C e&p at the end of the year, an S corporation is subject to the passive income penalty tax of Code Sec. 1375. In general terms, this tax is imposed at the highest corporate rate (currently 35%) on the lesser of (1) the S corporation's excess net passive income or (2) the S corporation's taxable income for the year (computed as if the S corporation were a C corporation).
Rule #2: If the S corporation has C e&p and its passive investment income exceeds the 25% gross receipts threshold for each of three consecutive years (whether or not the S corporation is subject to a penalty tax under rule #1), its S corporation status will be terminated as of the beginning of its fourth year. Code Sec. 1362(d)(3).
Let's now take a look at a typical situation where these rules raise their heads. The Soccer Etc. Corporation was formed in the mid-70s by an ex-athlete (let's call her Mia) who was sure that soccer would catch on in this country. The corporation owns a chain of stores selling soccer shoes, apparel and related items. In the early years, the corporation was moderately successful and was able to build its inventory and expand its locations through reinvesting earnings on which it paid tax at the lower C corporation surtax rates (currently, 15% on the first $50,000 of earnings and 25% on the next $25,000 of earnings). Along comes the 1986 Tax Act and its repeal of the General Utilities doctrine (i.e., the ability to sell a business and liquidate and pay only one level of tax) and Mia, like many of her fellow closely-held business owners, opted to make an S election on behalf of Soccer Etc. At the time of the S election, the corporation had C e&p of $1,000,000.
It's now 1999 and it turns out that Mia was right on target in her prediction that soccer would score in this country. However, Mia is getting on in years and has no logical successor to take over her business. She scores the hat trick by receiving a $5,000,000 offer for the assets of her small chain, which she accepts, as she retires to become a spectator at the World Cup games.
To make things simple, let's assume that the fair market value and basis of Soccer Etc.'s tangible assets are both equal to $1,000,000 (the amount of the S corporation's C e&p), and that, before the asset sale, Mia's basis for her S corporation stock was zero. The remainder of the sale price is attributable to goodwill and going concern value, meaning that the sale of assets will produce a capital gain of $4,000,000. (Note that Soccer Etc. is not subject to the built-in gains tax of Code Sec. 1374.) If Mia liquidates the corporation, the distribution of the $5,000,000 of sale proceeds will produce an additional capital gain of $1,000,000 ($5,000,000 of proceeds vs. $4,000,000 of basis). Consequently, Mia would like to distribute only $4,000,000 and retain the $1,000,000 in the corporation. Upon her death, there would be a step-up in basis of her stock to $1,000,000, enabling her estate (or heirs) to liquidate the corporation on a tax-free basis.
What's going to happen, however, is that the $1,000,000 likely will be invested in a portfolio of marketable securities. After all, if Mia wanted to invest in an active trade or business she likely would not have sold her business. Consequently, the income of Soccer Etc. will be comprised of interest, dividends and gains from sale or exchange of stock or securities. All this income will constitute passive investment income potentially subject to the Code Sec. 1375 penalty tax and the eventual loss of S status under Code Sec. 1362(d)(3).
This dilemma also arises in situations in which all the assets of a business operated by a C corporation are sold, and its owner would like to avoid liquidating the C corporation, so as to avoid the second layer of tax. Keeping the C corporation alive, however, presents personal holding company tax (Code Sec. 541) and accumulated earnings tax (Code Sec. 531) issues, when the corporation's assets are now all investment assets. Making an S election solves these issues for all years in which the S election is effective, because an S corporation is not subject to these penalty taxes (although the corporation still must often contend with accumulated earnings tax issues for its last C corporation year). However, just as in the first fact pattern described above, the S corporation passive investment income penalty tax and the potential loss of the corporation's S status must now be addressed.
Focusing on Mia again, Soccer Etc. can attempt to solve its passive investment income problem in several ways. One possibility would be to pay a dividend to Mia in the amount of its C e&p, because the passive investment income problem only exists if the S corporation has C e&p at the end of its taxable year. However, it would be silly for Mia to pay tax at a 40% rate on Soccer Etc.'s C e&p--it would make more sense to liquidate and pay tax at a 20% rate. In other situations, where the C e&p is substantially less than the amount of the corporation's remaining assets, a dividend might make sense, but not here. Also note, in other situations the amount of C e&p might exceed the corporation's available cash, in which case other property must be distributed to eliminate the C e&p. In the event this property has a value in excess of its basis, the distribution will be treated as a sale of the property.
Another possible solution to the Code Sec. 1375 penalty tax (but not the eventual loss of S status), is for Soccer Etc. to pay salaries and bonuses to Mia in an amount to eliminate or greatly reduce its taxable income. Even if Soccer Etc. is generating only passive investment income, the penalty tax is not imposed on any amount greater than its "taxable income." The problem here is that because the corporation, after the sale, only holds investment assets, it is unlikely that it can justify paying sufficient reasonable compensation to Mia so as to greatly reduce its taxable income.
Because these avenues often do not solve the excess passive investment income problem, it is becoming increasingly common for an S corporation to acquire a partnership interest in a partnership that generates gross receipts that do not constitute passive investment income. In Rev. Rul. 71-455, 1971-2 CB 318, the IRS ruled that for purposes of the excess passive investment income rules, an S corporation should consider its distributive share of a partnership's gross receipts, rather than its distributive share of the partnership's income or loss, in determining whether it was subject to the passive investment income penalty tax. This ruling further noted that because items of income maintain their character as they flow-through to the partners, the partnership's gross receipts were not converted into passive income as they flowed through to the S corporation partner. Various private letter rulings (e.g., PLR 8931007 and PLR 8804015) have applied these concepts to a limited partner interest acquired by an S corporation. Consequently, it historically has been believed that it is possible for an S corporation to invest in an operating business, limit its risk by reason of its status as a limited partner, and cleanse its mixture of gross receipts so as to avoid the adverse effects of Code Secs. 1375 and 1362(d)(3). (Note, however, that Rev. Rul. 71-455 involved a general partner interest, not a limited partner interest.)
The problem, however, is finding a partnership that generates "good" (i.e., non-passive) gross receipts, only requires a reasonable investment of cash to generate these receipts, and also does not constitute a venture with unacceptable risk levels. In addition, although tax planning to ameliorate the effect of General Utilities repeal (and the possible imposition of double-tax upon the sale of a corporate business) has made the partnership form of doing business much more common, there are still relatively few partnerships conducting operating businesses that are seeking investors. It is sometimes possible to find a business that needs an infusion of capital and that generates "good" gross receipts with an acceptable amount of risk that would be willing to contribute its business assets and liabilities into a partnership (or an LLC) in which a corporation in the position of Soccer Etc. could obtain a limited partnership interest (or LLC member interest). However, finding the right mixture of risk and gross receipts for a reasonable amount of investment dollars in an acceptable partnership (or LLC) format is not easy.
A potential solution to the dilemma of finding the right partnership in which Soccer Etc. can invest as a limited partner is the publicly traded partnership ("PTP"). In fact, in PLR 9144024 the IRS sanctioned the investment by an S corporation in a PTP for the purpose of obtaining "good" gross receipts and solving its passive investment income problems.
A PTP is defined by Code Sec. 7704 as any partnership the interests in which are traded on an established securities market or are readily tradeable on a secondary market. Beginning in 1988, most PTPs were taxed as corporations. But there were exceptions. Most PTPs that were in existence on December 17, 1987, and which did not add a substantial new line of business, were still taxed as partnerships through 1997. After 1997, a PTP subject to these rules could remain subject to partnership taxation; however, it is subject to a tax equal to 3.5% of its gross income. As a result of the magnitude of this tax, many PTPs did not elect to pay the tax and converted to corporate tax status beginning in 1998.
There remains, however, one major exception to a PTP being taxed as a corporation or being subject to the 3.5% gross income tax. For taxable years beginning after December 31, 1997, a PTP will continue to be taxed as a partnership, and not as a corporation, only if 90% or more of its gross income for the taxable year consists of qualifying income. Unfortunately, for purposes of solving the S corporation excess passive investment income problems, most types of qualifying income also constitute passive investment income. However, income and gains derived from the exploration, development, mining or production, processing, refining, transportation or marketing of a mineral or natural resource do constitute qualifying income for purposes of the PTP rules and, as set forth in PLR 9144024, do not constitute passive investment income that would subject an S corporation to the passive income penalty tax or cause it to lose its S status.
The facts of PLR 9144024 dealt with an S corporation that had Ce&p and had invested in a PTP that generated more than 90% of its gross income from "natural resource" qualifying sources. The ruling specifically focused on the penalty tax of Code Sec. 1375 and the possible termination of the corporation's S status under Code Sec. 1362(d)(3) and held that the S corporation's distributive share of the PTP's gross receipts flowed-through to the S corporation and retained its character as natural resource gross receipts. The ruling also specifically concluded that "natural resource" qualifying income under Code Sec. 7704(d) does not constitute S corporation passive investment income.
For years, tax professionals have been relying on Rev. Rul. 71-455 and PLR 9144024 as the basis for investing in a "natural resource" PTP as the basis of "cleansing" an S corporation's gross receipts. Assuming that the S corporation is comfortable from a risk standpoint in investing in such a PTP, and the S corporation's distributive share of the PTP's gross receipts is large enough to bring its passive investment income under the 25% threshold, it was believed that its investment in the PTP would solve the S corporation's excess passive investment income problem. However, last year we heard through the grapevine that someone in the S corporation rulings division at Treasury posited that the IRS was rethinking its position. An unnamed IRS representative was quoted as saying that Rev. Rul. 71-455 was distinguishable because it involved a general partner, rather than a limited partner, and that PLR 9144024 was a "rogue" ruling.
No one is quite sure what was meant by the description of PLR 9144024 as a "rogue" ruling, but the essence of the conversation was that perhaps the PTP solution was not as clear as once envisioned. Last month, however, the IRS issued PLR 199923007, which reaches the same conclusion as PLR 9144024, although in PLR 199923007 the ruling states that the S corporation's reason for investing in the PTP was "to provide liquidity and also to diversify risk." No statement of any intent or business purpose was set forth in PLR 9144024, although there may not be any significance to the differences in the factual recitals in each of the rulings. It would appear, that at least as of now, the PTP solution for an S corporation with excess passive investment income is still viable.