1995 Final Regulations and Qualified Subchapter S Trusts (QSSTs)
Thomas P. Langdon

What Was the Situation Before?

Before the enactment of the final regulations in 1995, many questions regarding the use of trusts as S corporation shareholders prevented practitioners from utilizing such vehicles. Recall that only individuals and qualifying trusts were eligible shareholders in an S corporation prior to 1997.

What Is the Nature of the Change?

In 1995, the IRS made the use of trusts to hold S corporation stock more flexible by clarifying the requirements for qualified Subchapter S trusts (QSSTs). Only individuals and qualifying trusts and estates are permissible shareholders of S corporation stock. Trusts that qualify to hold S corporation stock include grantor trusts (Subpart E trusts) for a 2-year period ⁷, voting trusts (if the trust is created by a written instrument containing specific provisions set forth in the regulations), and testamentary trusts to the earlier of the disposition of the stock or 60 days ⁸ after the stock is transferred to the trust. Grantor trusts permit the settlor of the trust to retain sufficient control or enjoyment of the property so that he or she is still considered to be the "owner" of the property for tax purposes. Grantor trusts are governed by Sec. 671 of the Internal Revenue Code. If a grantor trust is used to hold S corporation stock, at the expiration of the 2-year period provided for by Code Sec. 1361(c)(2)(A)(ii), the trust ceases to be an eligible S corporation shareholder unless the income beneficiary makes a valid QSST election under Code Sec. 1361(d)(2). Failure to make the proper election can result in termination of the S corporation election.⁹

7. IRC Sec. 1361(c)(2)(A)(ii).

8. For tax years beginning after December 31, 1996, the 60-day period for testamentary trusts is extended to 2 years.  This change puts testamentary and subpart E trusts on equal footing with respect to the period during which they can hold S stock.

9. PLR 9533006.

QSSTs are defined in Code Sec. 1361(d)(3). In order to qualify as a QSST, the trust must have only one income beneficiary during the life of the current income beneficiary.¹⁰ A trust with a single surviving income beneficiary meets the definition of a QSST, assuming that there is only one income beneficiary at the time the trust receives the S corporation stock.¹¹ The trust must stipulate that any corpus of the trust that is distributed during the life of the current income beneficiary must be distributed only to that beneficiary.¹² No sprinkle powers over a class of beneficiaries are permitted. The income interest of the current beneficiary must terminate on the earlier of the beneficiary’s death or the termination of the trust ¹³, and upon termination of the trust during the current beneficiary’s lifetime, all assets must be distributed to that beneficiary.¹⁴ Furthermore, all income of the trust must be distributed (or is required to be distributed) currently to one individual who is a citizen of the United States.¹⁵ If a court order awards an interest in the trust to a person other than the income beneficiary, QSST status is lost, resulting in termination of the S corporation election. Flexibility as to non-Subchapter S income can be achieved by structuring the trust so that S corporation stock is held in a separate trust (sub trust) that meets the QSST requirements.¹⁶ These requirements apply from the date the QSST election is made through the term of the trust. The requirements need not be met during any period prior to the acquisition of S corporation stock by the trust, but once the requirements are in place and the trust qualifies as a QSST, the requirements cannot be ignored when the trust no longer holds S corporation stock.¹⁷

10. IRC Sec. 1361(d)(3)(A)(i).

11. PLR 9543024.

12. IRC Sec. 1361(d)(3)(A)(ii).

13. IRC Sec. 1361(d)(3)(A)(iii).

14. IRC Sec. 1361(d)(3)(A)(iv).

15. IRC Sec. 1361(d)(3)(B).

16. Rev. Rul. 92-90, 1992-1 C.B. 685.

17. Treas. Reg. Sec. 1.1361-1(h)(1)(i).

When a QSST is established, the beneficiary of the trust is treated as the owner of the trust’s S corporation stock. Whether or not a distribution of income is made from the trust, the beneficiary will be taxed as if he or she owned the shares in the S corporation outright. The S corporation will pass through all items of income and loss to the beneficiary through the trust regardless of whether the beneficiary ever receives a distribution from the corporation through the trust.¹⁸ A QSST must recognize any gain on the sale of S corporation stock by the trust. This overturns the position taken by the IRS in Rev. Rul. 92-84, which required a QSST’s current income beneficiary to recognize the gain on the sale of stock by the trust.¹⁹

18. IRC Sec. 1361(d)(1)(B).

19. Treas. Reg. Sec. 1.1361-1(j)(8).

When Does This Change Affect Clients?

The final regulations became effective in 1995.

What Should Be Done?

The final regulations to Code Sec. 1361 include provisions that make the QSST a more flexible planning mechanism. For example, if a husband and wife are both beneficiaries of a trust, are both U.S. citizens, and file a joint income tax return, they will be treated as a single beneficiary for purposes of meeting the QSST requirements.²⁰ If a trust is established to satisfy the grantor’s legal obligation to support the income beneficiary, however, the trust will not qualify as, or will cease to be, a QSST as of the date of the disqualifying distribution.²¹ Therefore, care should be exercised in setting up a QSST to ensure that the trust will not be disqualified because it meets a support obligation. In such a case, termination of QSST status occurs because the grantor would be treated as the owner of the income interest of the trust or, alternatively, would be treated as the beneficiary of the trust under Code Sec. 662 and Treas. Reg. Sec. 1.662(a)-4. In fact, to elect QSST status, the election statement must include sufficient information to show that "no distribution of income or corpus by the trust will be in satisfaction of the grantor’s legal obligation to support or maintain the income beneficiary."²²

20. Treas. Reg. Sec. 1.1361-1(j)(2)(i).

21. IRC Sec. 667(b) and Treas. Reg. Sec. 1.677(b)-1.

22. Treas. Reg. Sec. 1.1361-1(j)(6)(ii)(E)(3).

The final regulations under Sec. 1361 also make it clear that a qualified terminable interest property trust (QTIP trust) that qualifies under Code Sec. 2056(b)(7) can qualify as a QSST and be a permitted S corporation shareholder. This may be an important provision for the owners of S corporation stock. A trust that qualifies as a QTIP trust for gift tax purposes under Code Sec. 2523(f) cannot qualify as a QSST because the grantor would be treated as the owner of the income portion of the trust pursuant to the provisions of Code Sec. 677.

Example: William and Ellen are the sole owners of XYZ Closely Held Corporation. XYZ is currently organized as an S corporation and has made all appropriate filings and elections. William owns 80 percent of the stock, and Ellen owns 20 percent. William’s 80 percent share is valued at $2 million at his death.

Pursuant to the terms of William’s will, his interest in the S corporation is to be divided into two separate trusts; both trusts have Ellen as the sole income beneficiary for life. One trust, the credit shelter trust, is to be funded with an amount that can pass free of estate tax under William’s unified credit. The terms of the credit shelter trust meet the requirements of IRC Sec. 1361(d)(3) as a QSST. The balance of the property passes to a marital trust, whose terms satisfy the requirements of Sec. 1361(d)(3) as a QSST and Sec. 2056(b)(7) as a QTIP.

In order to qualify the trusts as QSSTs, Ellen must file an election within the 16-day and 2-month period beginning on the date the stock is transferred to the trust. The election is made by signing and filing with the service center with which the S corporation files its income tax return an applicable form or statement that

• contains the name, address, and taxpayer identification number of the current income beneficiary, the trust, and the corporation
• identifies the election as an election made under Sec. 1361(d)(2)
• specifies the date on which the election is to become effective
• specifies the date on which the stock of the corporation was transferred to the trust
• provides all information and representations necessary to show that the trust meets the definition of a QSST

Once Ellen files the appropriate election, both the credit shelter and marital deduction trusts qualify as QSSTs.²³

^{23. Treas. Reg. Secs. 1.136-1(j)(4), 1.1361-1(j)(6)(ii), and 1.1361-1(k)(1).}

As long as a client is willing to comply with the restrictive provisions found in the regulations, QSSTs can be helpful in business and estate planning.

Where Can I Find Out More?

• GS 836 Business Succession Planning I. The American College.
• IRC Sec. 1361(d).
• Thomas P. Langdon. "IRS Hands Greater Flexibility to S Corporations." Best’s Review, Life/Health Edition (February 1997), p. 74.
• Tom Ochsenschlager. "S Corps Finally Get in Shape to Compete." Family Business (August 1996), p. 52.
• Laura Saunders. "The Family Business Preservation Act." Forbes (November 18, 1996), pp. 268–270.
• Stephanie Rapkin. "The Basics of the S Corporation for the Estate Planner." Trusts & Estates (September 1996), pp. 38–44.

Electing Small Business Trusts (ESBTs)
Thomas P. Langdon

What Was the Situation Before?

Prior to the enactment of the 1996 Small Business Job Protection Act, the only types of trusts eligible to hold S corporation stock were grantor trusts (for a period of 2 years), testamentary trusts (for a period of 60 days), and QSSTs.

What Is the Nature of the Change?

The 1996 Small Business Job Protection Act creates a more flexible option for trust ownership of S corporation stock, the electing small business trust (ESBT). Unlike the QSST, the ESBT has virtually no restrictions on dispositive terms, and allows the trust to have multiple beneficiaries. All beneficiaries must be individuals or eligible estates, or charitable organizations with contingent remainder interests. Because an ESBT may have more than one current income beneficiary, a unified credit shelter trust that allows the trustee to sprinkle income among a class of beneficiaries or to distribute principal among several beneficiaries could qualify as an ESBT. No interest in the trust can be acquired by purchase, and each potential current beneficiary is counted as a shareholder. This additional flexibility, as compared to the QSST, comes at a cost, however. All S corporation income and the proceeds from sales of S corporation stock are taxed at the highest marginal rate imposed on estates and trusts¾ currently 39.6 percent, regardless of whether the income is accumulated or distributed. No deductions are allowed from this income except state and local taxes, and administration expenses.

When Does This Change Affect Clients?

ESBTs are available for use for tax years beginning after December 31, 1996.

What Should Be Done?

Due to the compressed rate schedule for trusts, the ESBT will not be useful unless all of the beneficiaries of the proposed trust are already in the highest marginal tax brackets. Under current law, a trust is taxed at its highest marginal rate once it reaches $7,500 in income.

If the beneficiaries of the proposed ESBT are already in the highest marginal tax bracket, the taxation of the trust does not impose an additional burden. Under these circumstances, an ESBT can be used for business planning purposes for a minimal incremental cost (administration fees) to the beneficiaries. Furthermore, if investment income earned in an S corporation owned by an ESBT avoids or defers local taxes until actual distribution, the ESBT can be used as a tax planning tool beyond standard estate planning needs.²⁴

^{24. Gerald S. Susman, "New, More Flexible S Corporation Trust Comes Out of Small Business [sic] Act," The Legal Intelligencer, (September 10, 1996), p. 10.}

Where Can I Find Out More?

• GS 836 Business Succession Planning I. The American College.
• IRC Secs. 1361(c)(2)(A)(v), 1361(c)(2)(B)(v), 1361(e), and 641(d).
• Thomas P. Langdon. "IRS Hands Greater Flexibility to S Corporations." Best’s Review, Life/Health Edition (February 1997), p. 74.
• Gerald S. Susman. "New, More Flexible S Corporation Trust Comes Out of Small Business [sic] Act." The Legal Intelligencer (September 10, 1996), p. 10.
• "New S Trust Offers Flexibility But at a Price." Federal Taxes Weekly Alert (August 22, 1996), p. 408.

Changes to Safe Harbor Debt Rules
Thomas P. Langdon

What Was the Situation Before?

One of the difficult problems facing an S corporation prior to the Subchapter S Revision Act of 1982 was whether certain shareholder loans to the corporation would be regarded as bona fide debt or as equity interest. If the debt was classified as an equity interest, the IRS could then reclassify the debt as a disqualifying second class of stock.

Straight debt will not be treated as a second class of stock. Straight debt is defined as any written unconditional promise to pay on demand or on a specified date a certain sum of money if

• the interest rate and the dates are not contingent on corporate profits, the borrower’s discretion, or similar factors
• the debt is not convertible into stock
• the creditor is an individual, estate, or trust eligible to hold stock in an S corporation

Note that under the old rules, the only safe harbor debt available was debt held by an eligible shareholder of S corporation stock.

What Is the Nature of the Change?

Congress recognized that it is often beneficial for business owners to obtain commercial financing for business operations. For S corporations, however, the only debt meeting the safe harbor requirements of straight debt is that owned by an individual, estate, or trust eligible to hold S corporation stock. The 1996 Small Business Job Protection Act expands the definition of straight debt to include debt held by individuals and institutions that are regularly engaged in the business of extending credit.

When Does This Change Affect Clients?

The expanded definition of straight debt is effective for tax years beginning after December 31, 1996.

What Should Be Done?

No affirmative actions need be taken by the taxpayer. Both existing S corporations and newly organized companies will be eligible to treat debt issued to individuals and institutions that are regularly engaged in the business of extending credit as straight debt for tax years beginning after December 31, 1996.

Where Can I Find Out More?

• GS 836 Business Succession Planning I. The American College.
• 1996 Small Business Job Protection Act, Sec. 1304 amending IRC Sec. 1361(c)(5)(B)(iii).

S Corporation Stock and Sec. 1014 Step Up in Basis
Thomas P. Langdon

What Was the Situation Before?

Under prior law, an individual who inherited S corporation stock from a deceased shareholder received the stock with a basis equal to its fair market value on the date of the decedent’s death or, if elected, on the alternative valuation date. No adjustment was made for the proportionate share of income of the corporation that would have been income in respect of a decedent (IRD) if the income had been acquired directly from the decedent.

What Is the Nature of the Change?

A person who inherits S corporation stock must treat as IRD the pro rata share of income of the corporation that would have been IRD if the income had been acquired directly from the decedent. The purpose of this provision is to equate the treatment of IRD for S corporation owners with the treatment of IRD for members of partnerships.

When Does This Change Affect Clients?

This change is effective with respect to decedents dying after August 20, 1996.

What Should Be Done?

No affirmative action is required on the planner’s part. Administrators and executors of the estates of decedents holding S corporation stock must, however, comply with this new provision in administering the estate and filing the appropriate tax forms.

Where Can I Find Out More?

• GS 836 Business Succession Planning I. The American College.
• 1996 Small Business Job Protection Act, Sec. 1313(a), adding IRC Sec. 1367(b)(4)(A) and (B).

Limited Liability Companies (LLCs) and the New Entity Classification Scheme
Thomas P. Langdon

Introduction

Limited Liability Companies Defined. Limited liability companies (LLCs) are hybrid entities. They combine the best attributes of both partnerships and corporations. Legally, an LLC is an unincorporated business entity that provides limited liability for all its members. Prior to the advent of LLCs, the only way to obtain limited liability for all members of the business entity was to incorporate and be classified as either a C corporation (a regular corporation subject to double taxation) or an S corporation (a corporation under state law that attains pass-through taxation at the federal level). While limited partnerships were able to extend limited liability to some of their members, called limited partners, the general partners of a limited partnership had unlimited liability for business debts. The principal difference between an LLC and an S corporation, aside from the fact that the S corporation is incorporated and the LLC is not, is that an LLC is taxed according to the provisions of Subchapter K of the Internal Revenue Code (the partnership tax provisions), while the S corporation is taxed in accordance with Subchapter S. S corporations are pass-through entities, like partnerships, but, because they are incorporated, some elements of corporate taxation still apply.

Advantages and Disadvantages of Limited Liability Companies. The primary advantages of LLCs are inherent in their description—they offer limited liability to all their members, yet qualify for Subchapter K tax treatment. LLCs are superb estate and business succession planning vehicles because control of the LLC can be maintained by a senior generation while substantial interests in the business entity are transferred to younger-generation family members.

Counterbalancing these advantages is the fact that the LLC is a new business entity, and some uncertainty exists regarding how a domestic LLC will be treated outside the state boundaries. As of June 1996, every state has enacted an LLC statute, and about half the states have enacted LLP (limited liability partnership) statutes. Each state statute differs, and some concern has been expressed as to whether the limited liability conferred by one state will be respected by another state when the business entity is sued outside of its state of origin. While uncertainly still exits, principles of comity should ensure that the liability shield will be respected. Now that all states have LLC statutes, it is likely that efforts will be made to propose a uniform statute that can be tailored to each state’s individual needs. The new IRS regulations that change the entity classification rules will give many states the opportunity to review their statutes and bring them into line with federal tax standards and the laws of other states.

Classification of Business Entities for Federal Tax Purposes

What Was the Situation Before?

When individuals organize a business, they must look to state law to determine how that business will be formed. State law defines the requirements for incorporation, limited partnerships, general partnerships, and LLCs. While state law determines the form in which a business operates, the state law characterization of that business is not binding for federal tax purposes. For purposes of federal taxation, if a business entity was organized as a corporation under state or federal law, it would be treated as such. A corporation organized under state law that meets the Subchapter S requirements may file an election to change the manner in which it is taxed (for federal tax purposes) from the normal rules under Subchapter C to the pass-through rules under Subchapter S.

Under the old entity classification scheme, the fact that a business entity (with two or more owners or members) was an unincorporated entity under state law did not mean that it automatically qualified for partnership tax treatment under federal law. The old rules may have classified the business as an association taxable as a corporation for federal tax purposes. In order to determine how an unincorporated business entity is taxed, the IRS used to examine traditional corporate attributes.

As discussed above, an LLC offers limited liability for all its members, yet is taxed as a partnership for federal tax purposes. The reason an LLC was able to achieve limited liability for its members while avoiding double taxation comes from a 1935 Supreme Court case called Morrissey.²⁵ In the Morrissey case, the Supreme Court set forth the corporate characteristics that determine whether an entity is taxed as a corporation or a partnership for federal tax purposes. These characteristics are limited liability, centralized management, continuity of life, and free transferability of interest. If an organization possesses three or more of these characteristics, it is taxed as a corporation. If, however, the organization avoids two of these characteristics, it is taxed as a partnership. Because this test required a delicate balancing between corporate and non-corporate characteristics, individuals setting up LLCs prior to the proposal of the check-the-box regulations had to engage in very careful (and expensive) planning with their advisers and attorneys.

25. Morrissey v. Comm'r., 296 U.S. 344, 16 AFTR 1247, 36-1 USTC Par. 9020 (S. Ct., 1935).

One of the reasons LLCs were able to be classified as partnerships for federal income tax purposes is that the IRS, in developing entity classification regulations to implement the Morrissey test, worked in a bias that favored the partnership form of taxation over the corporate form. Subsequent to the Morrissey case, many professional practices (involving doctors and lawyers) which were forbidden from establishing corporations under state law, sought to classify their business entities as corporations for federal tax purposes in order to take advantage of qualified retirement plan benefits which, at that time, were only available to corporations. At least one group of doctors was successful in accomplishing this objective.²⁶ After losing a hotly contested court case in which the IRS argued that partnership taxation should apply (thereby denying eligibility for the qualified retirement plan benefits) the IRS issued entity classification regulations which favored partnership taxation over corporate taxation.²⁷

26. Kinter v. Comm'r., 216 F.2d 418, 46 AFTR 995, 54-2 USTC Par. 9626 (CA-9, 1954).

27. Treas. Reg. Sec. 301.7701-1 through 301.7701-3.

Now that unincorporated business entities are essentially in parity with incorporated entities for qualified retirement plan purposes, business owners are not inclined to incorporate solely to take advantage of pension benefits. Furthermore, the General Utilities doctrine (which held that a corporate distribution of property was subject to only one level of tax) was legislatively repealed by the Tax Reform Act of 1986, requiring double taxation on corporate distributions of property. For these and other reasons, it is now generally preferable to be subject to the partnership tax rules at the federal level. Taking advantage of the test set forth in Morrissey, and the bias for partnership taxation which the IRS wrote into the entity classification regulations, the states enacted LLC statutes which allowed entities to structure themselves as partnerships for tax purposes while at the same time achieving limited liability for all members of the entity. While the IRS was successful in achieving a preference for partnership taxation at the time it wrote the regulations (thereby minimizing deductions allowable for qualified plan benefits), when the tax situation changed, the regulations intended to favor the IRS now favor the taxpayer.

What Is the Nature of the Change?

Newly adopted regulations (the check-the-box regulations) have greatly simplified the old entity classification test for unincorporated entities. The check-the-box regulations, as adopted, change the entity classification scheme from the balancing approach set forth by the Morrissey case and the Treasury regulations to a right to choose. As the IRS recognized in its explanation of the proposed revisions, "The existing regulations for classifying business organizations as associations (which are taxable as corporations...) or as partnerships...are based on the historical differences under local law between partnerships and corporations. However, many states have revised their statutes to provide that partnerships and other unincorporated organizations may possess characteristics that traditionally have been associated with corporations, thereby narrowing considerably the traditional distinctions between corporations and partnerships under local law." Since 1988 the IRS has invested considerable time in interpreting state LLC statutes and issuing rulings on specific transactions proposed by taxpayers. In response to these developments, the "Treasury and IRS believe that it is appropriate to replace the increasingly formalistic rules under the current regulations with a much simpler approach that generally is elective."²⁸

^{28. IRS explanation of provisions to the proposed regulations, issued May 13, 1996.}

The first step in the new classification process is to determine whether there is a separate entity for federal tax purposes. A business entity is any entity recognized for federal tax purposes that is not properly classified as a trust. (The proposed regulations are not intended to change the federal tax scheme for trusts, and therefore the Morrissey test still applies in this area.)

The second step looks to see how many members own the business entity. A business entity with two or more members is classified for tax purposes as either a corporation or a partnership. In general, business entities incorporated under state or federal law, joint-stock companies or joint stock associations, insurance companies and banks, business entities owned wholly by a state or political subdivision of a state, publicly traded partnerships, and certain enumerated foreign entities are considered per se corporations under the new regulation. These organizations are taxed as corporations and are not be permitted to elect partnership taxation. Unincorporated businesses and entities with two or more members that are not per se corporations are eligible to choose corporate or partnership taxation for federal tax purposes. A business entity with only one member is classified as a corporation or is disregarded and is treated in the same manner as a sole proprietorship, branch, or division of the owner. Special classification provisions are included for foreign business entities.

While the new regulation speaks of an election, the current classification of existing entities will be respected if there was a reasonable basis for the classification, the same classification was claimed on all prior tax returns, and neither the entity nor any of its members was advised that the IRS was auditing the classification of the entity prior to May 8, 1996. Newly formed entities are not required to make an election. Instead, default rules apply. The default rules are designed to make the choice the entity would have made had an election been filed. Under the default rule, a domestic business entity with two or more members will automatically be classified as a partnership for federal tax purposes. For domestic business entities with only one member, the default rule disregards the entity, requiring treatment as a sole proprietorship. If the default classification is not desired, an election out of that classification is effective on either the date specified in the election if that date is within 75 days of the date the election is filed, or, if no date is specified, on the date the election is filed. Once an entity elects to change its classification it must wait 60 months (5 years) before it is able to change its classification again.

When Does This Change Affect Clients?

The check-the-box regulations became effective January 1, 1997. For entities formed before May 8, 1996 (the publication date of the proposed check-the-box regulations), a special provision applies. As noted above, if the IRS had failed to challenge (by way of an audit) the classification of a business entity prior to May 8, 1996, the entity had a reasonable basis for the classification, and the same classification was claimed on all prior tax returns, the entity has met the safe harbor provisions in the regulation, and its status will not be challenged by the IRS.

What Should Be Done?

The effect of the new regulations is to reduce the federal tax uncertainty faced by the client when forming an LLC under state law. Planners must proceed with caution, however. Many states based their LLC statutes on the 4 factor balancing test set forth by the Morrissey case. In those states, compliance with the balancing test may still be required to form an LLC. It is likely, however, that most states will revise their LLC statutes to bring them in line with the new regulations. Furthermore, be aware that if an entity, currently taxed as a corporation, elects to be taxed as a partnership, the election causes a liquidation of the corporation, triggering potentially huge tax liabilities at both the corporate and shareholder levels. While the regulations represent a step in the right direction, planners should not be too hasty to employ them without first considering the impact of an election on the business entity and client.

Conclusion

The IRS, in adopting the check-the-box regulations, has simplified the entity classification scheme and, by doing so, has made it easier for clients to choose the LLC as the preferred form of business. Because an LLC is more flexible than an S corporation with respect to planning opportunities, in almost all cases where a client is setting up a new business, the LLC will be preferred to an S corporation. The next article explores the tax advantages and disadvantages of the LLC versus the S corporation.

Where Can I Find Out More?

• HS 331 Planning for Business Owners and Professionals. The American College.
• GS 836 Business Succession Planning I. The American College.
• GS 838 Business Succession Planning II. The American College.
• Thomas P. Langdon. "Will Proposed IRS Rules Simplify Client Planning?" Best’s Review, Life/Health Edition (October 1996), p. 98.
• Lewis J. Saret and Lewis D. Solomon. "New IRS ‘Check the Box’ Regulations." Journal of Asset Protection,Vol. 1, No. 6 (July/August 1996), pp. 67–72.
• Francis J. Wirtz. "Check-the-Box: The Proposed Regulations on Entity Classification." Taxes, Vol. 74, No. 6 (June 1996), pp. 355–364.

A Comparison of Limited Liability Companies and S Corporations in Planning for Closely Held or Family-Owned Businesses
Thomas P. Langdon

Given the substantial changes in S corporation rules and the enactment of the check-the-box regulations discussed in previous articles, the planner should carefully compare the advantages and disadvantages of the two forms of business to make appropriate choices for clients. The purpose of this article is to summarize the advantages and disadvantages of S corporations and limited liability companies (LLCs) in light of recent legislative and regulatory changes. Here is a summary of the topics covered in this article:

Planning Issues

1. Asset Protection Aspects

S Corporations. Because S corporations are formed under state law, they possess the desirable characteristic of limited liability. Limited liability shields the owner of the business (the stockholder) from liability for business debts in excess of his or her investment. Creditors of the business do, however, have access to the business assets to satisfy their claims. If a creditor attaches and sells an asset vital to the continued operation of the S corporation, the business may fail.

For closely held and family businesses, protection from the claims of the owners’ creditors, as well as the business’s creditors, is an important planning goal. If an owner of S corporation stock experiences financial difficulty and files for bankruptcy, the S corporation stock is part of the bankruptcy estate, and is available to creditors to satisfy their claims. If creditors receive the stock in satisfaction of the shareholder’s debt, outsiders now have voting power in the closely held or family business. Worse yet, if creditors sell the S corporation stock to an ineligible shareholder, the S corporation election is terminated, and the business is subject to the double-level tax assessed on C corporations.

These issues require careful planning on the part of S corporation owners. Buy-sell agreements can be structured to become effective on the death, disability, bankruptcy, or incapacity of any shareholder. Entering into a buy-sell agreement of this type will protect against outsiders obtaining a stake in the business and inadvertent termination of the S corporation election if the stock is sold to an ineligible shareholder. However, the buy-sell agreement itself will not protect individual shareholders from the claims of creditors because the value of the business interest will be available to satisfy creditor claims.

Limited Liability Companies. LLCs, like corporations, offer limited liability to all of their members. As such, an individual member’s liability for business debts is limited to his or her investment in the LLC.

When a shareholder in an S corporation declares bankruptcy, the S corporation stock is generally available to the shareholder’s creditors for satisfaction of the debt. Unless a buy-sell agreement is in place that takes effect upon bankruptcy or similar contingencies, it is possible that the creditor of an S corporation shareholder will acquire a voting interest in the corporation, or the stock will be sold to an ineligible shareholder, thereby terminating the S corporation election.

An LLC provides additional creditor protection to its members as compared with a shareholder in an S corporation. Most LLC statutes stipulate that a charging order is the exclusive remedy for creditors seeking to attach a member’s interest in an LLC. A charging order is "a statutorily created means for a creditor of a judgment debtor who is a partner of others to reach the debtor’s beneficial interest in the partnership, without risking dissolution of the partnership."²⁹ Under Sec. 25(2)(c) of the Uniform Partnership Act, partnership property may not be seized to satisfy a partner’s obligation. The creditor may only seize the right to receive distributions from the partnership or LLC until the obligation is satisfied. The holder of a charging order is treated as an assignee entitled to distributions under state law, but is treated as a partner for federal tax purposes.³⁰ Because the creditor is treated as a partner or member of an LLC for federal tax purposes, phantom income results to the extent that the business earned more than it distributed during the taxable year. Faced with the prospect of reporting and paying tax on phantom income, creditors will be more amenable to settling their claim for a reasonable amount. Furthermore, because the creditor is only an assignee for state law purposes, he or she does not obtain the right to vote on LLC matters, and, as a result, there is no dilution of control of the family business.

29. Uniform Partnership Act, Sec. 28.

30. Rev. Rul. 77-137, 1977-1 C.B. 178; Evans v. Comm'r, 477 F.2d 547 (7th Cir. 1971).

2. Business Planning Considerations

S Corporations. For many years, the only way to obtain limited liability for all owners of a business was to incorporate. Incorporation carried with it undesirable tax consequences, however, since a double-level tax is imposed on the earnings of regular corporations. The corporation, as a legal person in its own right, is taxed on its earnings. In addition, when the corporation passes its earnings out to its owners in the form of dividends, the owners are taxed on the dividend income. In order to provide relief for smaller businesses while allowing them to be organized as corporations, Congress passed Subchapter S of the Internal Revenue Code, allowing C corporations that meet certain requirements to elect pass-through treatment for federal tax purposes. Pass-through treatment results in a single-level tax on corporate earnings for federal tax purposes.

Obtaining pass-through treatment of corporate earnings comes at a significant cost, however. In order to get favorable pass-through treatment, the corporation must comply with the many requirements and restrictions discussed in a previous article. Not all corporations are eligible to make a Subchapter S election, and the limitation on the number and type of eligible shareholders often results in difficulty attracting investors. While recent legislative and regulatory changes have loosened the rules, the rules still demand compliance, thereby restricting the ability of the business to grow and compete with other businesses that are not subject to the litany of complex requirements under Subchapter S. New business entities must carefully consider the restrictions imposed by Subchapter S before deciding to organize as S corporations.

Limited Liability Companies. Unlike the situation with S corporations, there are no statutory restrictions on LLCs. An LLC may have an unlimited number of members, and there are no restrictions on the type of individuals or trusts eligible to hold an interest in the LLC. An LLC, like a partnership, may have both profits and capital interests in the entity and may structure ownership interests unequally between rights to distribution and rights to liquidation proceeds. Like a family limited partnership, an LLC can grant an interest only in profits to an important member of the management team. For example, the LLC could grant to its president or managing member a 5 percent interest in the profits of the LLC, even though no right to the underlying capital has been given away. If an S corporation tried to do this, it would terminate its S corporation status due to the "one class of stock" rule.

3. Retirement Planning Considerations

S Corporations. A significant planning opportunity available to owners of S corporation stock beginning in tax years after December 31, 1997 involves the use of S corporation stock to fund qualified retirement plans. Beginning in 1998, qualified retirement plans organized under Sec. 401(a) of the IRC will be eligible to hold S corporation stock. This means that employee stock ownership plans (ESOPs) can now be established for S corporations. Among the benefits of the ESOP is the ability to allow employees to participate in the ownership of the company, and to create a market for the S corporation stock. Use of S corporation stock in qualified retirement plans can serve many business and succession planning objectives, and should be explored by current S corporation owners. Because qualified plans are permissible shareholders beginning in 1998, the IRS will have the opportunity to issue guidance on the use of S corporation stock in qualified plans this year.

Limited Liability Companies. Because the members of LLCs are treated as partners for federal tax purposes, the restrictions encountered with retirement planning for partners are also present for members of LLCs.

4. Estate Planning Considerations

S Corporations. Owners of S corporation stock must also comply with the rules and restrictions of Subchapter S when engaged in estate planning. The most obvious restriction is that S corporation stock may not be left to an ineligible shareholder.

Trusts often play an important role in the estate planning process, yet only three types of trusts are eligible to hold S corporation stock. Grantor trusts are permitted to hold S corporation stock only for a 2-year period, which puts severe restrictions on the use of these trusts for estate planning purposes. This 2-year restriction can be overcome by electing qualified Subchapter S trust (QSST) status, but only if the grantor is willing to comply with another set of complex restrictions, the most significant being that these trusts can have only one current income beneficiary. Under the new provisions of the Small Business Job Protection Act of 1996, an electing small business trust (ESBT) is allowed to hold S corporation stock and have multiple beneficiaries, but only at a significant cost: all S corporation income is taxed at the highest marginal rate for estates and trusts. Furthermore, it is not yet clear whether charitable remainder trusts (CRTs)will be permitted to hold S corporation stock. Even if a CRT can hold S corporation stock, income attributed to the S corporation earnings, as well as gain realized on the sale of S corporation stock, will be taxed to the trust. (The taxation of S corporation earnings is presumably based on the premise that the trust, as a shareholder in a pass-through business entity, has unrelated business taxable income [UBTI].) Every trust permitted to hold S corporation stock has significant restrictions, thereby limiting the estate planning opportunities for S corporation owners.

For estate planning purposes, S corporations, like other business entities, may qualify for minority and lack of marketability discounts. These discounts allow individuals to leverage their unified credit and annual gift tax exclusion. For example, if an individual holds a 40 percent minority interest in an S corporation valued at $2,250,000, the shareholder’s proportional interest in the corporation is worth $900,000. If a 35 percent discount applies for the minority interest and lack of marketability, the 40 percent interest is worth only $585,000. This shareholder could pass the $900,000 proportional interest in the corporation to his or her heirs fully shielded by his or her unified credit of $600,000. In S corporations owned by families, this offers attractive wealth transfer opportunities.

The corporate form also makes transfer of control of the business relatively simple, since a transfer of a simple majority of the shares will transfer control. Often, this ability is limited by transfer restrictions placed in a buy-sell agreement to ensure that stock is not transferred to an ineligible shareholder. This serves as yet another example of how the rules complicate matters for owners of S corporations.

Overall, estate planning for S corporation owners is more intricate than planning for the owners of other business entities due to the myriad of complex rules that apply. Increased complexity in turn increases the cost of such planning, both in terms of time and money.

Limited Liability Companies. Unlike the case with S corporations, there are no restrictions on the types of individuals or trusts which can hold an interest in an LLC. By setting up a business as an LLC, it is possible to transfer a significant amount of the business interest to junior members of the family without losing any control. In fact, if the business owner makes full use of annual exclusion gifting, he or she can often transfer most of the value of the business to successive generations throughout his or her lifetime and still be in control. For business owners who wish to maximize their estate planning opportunities, therefore, the LLC is a more flexible tool than the S corporation.

Comparison of S Corporation Taxation to Partnership Taxation

Although an S corporation is taxed as a pass-through entity, it is not taxed under the provisions of the Internal Revenue Code dealing with partnerships. S corporations have their own set of rules, located in Subchapter S of the Code. The tax treatment of S corporations and partnerships is similar, but is not exactly the same; S corporation requirements and certain corporate tax attributes impose additional restrictions and requirements on the taxation of S corporations that are not found in the taxation of partnerships. While Subchapter K of the Code, dealing with partnership taxation, is arguably the most complex area of federal taxation, it provides more flexibility for business owners than Subchapter S. Some of the differences between partnership and S corporation taxation are discussed below.

1. Special Allocations

A partnership is permitted to make special allocations of tax items to its partners, provided that the allocation has substantial economic effect.³¹ Substantial economic effect generally means that the allocations of the tax items made among the partners are actually reflected in the partners’ capital accounts. An S corporation is not permitted to make special allocations. Making special allocations of tax items to S corporation shareholders would mean that the shareholders do not have identical rights to distributions and liquidation proceeds, thereby violating the "one class of stock" rule. Partnership tax treatment is therefore more flexible than S corporation tax treatment because the owners can tailor allocations of tax items in the most efficient fashion.

31. IRC Sec. 704(b).

2. Effect of the Business Entity Incurring Debt

While a partnership is itself a separate entity from its owners for state law purposes, it is not treated as such for federal tax purposes. Therefore, when a partnership incurs debt, for tax purposes the transaction is treated as though the partner contributed an amount of cash to the partnership equal to the partner’s pro rata share of the debt.³² When a partner makes a contribution of property to a partnership, the partner’s basis in the partnership is increased by the amount of the contribution.³³ The increase in basis increases the amount of partnership distributions that can be received tax free. The reason for this treatment may be that, traditionally, because a partnership does not offer limited liability to its members, an increase in partnership debt equates to an increased investment in the partnership, since the partner could be personally liable for that debt. While a member of an LLC, which is taxed as a partnership, will receive an increase in basis when the entity takes on debt, no personal liability for that amount results. This is an illustration of one area where the partnership tax rules favor an LLC over a partnership.

32. IRC Sec. 752.

33. IRC Sec. 705(a).

When an S corporation incurs debt, the corporation is liable for the debt, not the shareholder. Consequently, no basis step up is permitted for S corporation shareholders when the entity incurs debt. Practically speaking, owners of S corporations frequently have to personally guarantee corporate debts, which places them on a par with partners when a partnership incurs debt. Regardless of personal guarantees, no basis step up is permitted for S corporation owners when the corporation incurs debt.

3. Basis Change upon Transfer of Interest

Once an entity is formed, the basis of the entity’s assets in the entity’s hands (inside basis), and the basis of the owner’s interest in the owner’s hands (outside basis) begins to change, so that the inside basis does not equal the outside basis. Under Code Sec. 754, a partner is permitted to elect to equate or step up the inside and outside bases of the partnership interest upon transfer. This gives an advantage to the acquiring partner because, when the asset is sold, the acquiring partner will only recognize gain to the extent of the partner’s pro-rata share of the amount realized, less the section 754 stepped-up basis.

Owners of S corporation stock do not have the opportunity to equate inside and outside bases upon sale of an interest in the entity. As a result, when the underlying corporate assets are sold at a gain, this gain increases the shareholder’s basis and often places the shareholder in a loss position, because the basis of the stock (including the step up) may exceed the stock’s fair market value.

4. Contribution of Appreciated Property

When a partner contributes property to a partnership, no gain or loss is recognized.³⁴ When an S corporation owner contributes property to the corporation, gain or loss on the contributed property is recognized to the extent that the contributor owns less than 80 percent of the combined voting power of all classes of stock eligible to vote or less than 80 percent of all other shares of stock in the corporation immediately following the transfer.³⁵ Unless the owner of the S corporation stock can meet the 80 percent test, he or she will be discouraged from making additional contributions of capital to the business entity. This can minimize both business and estate planning opportunities for the affected business owners.

34. IRC Sec. 721(a).

35. IRC Secs. 351(a), 368(c).

5. Distributions of Property to the Owners

When property is distributed from a partnership to a partner, no gain or loss is recognized.³⁶ The partner takes a carryover basis in the property received from the partnership, provided the basis in the asset distributed is not in excess of the partner’s basis in the aggregate partnership interest.³⁷

^{36. IRC Sec. 731(a).}

^{37. IRC Sec. 732(a) and (b).}

When an S corporation distributes property to a shareholder, a gain equal to the difference between the asset’s fair market value and the corporation’s adjusted basis is recognized at the corporate level.³⁸ The gain is passed through to the shareholders on the K-1, and is therefore taxed only once, at the individual shareholder level. Because there has been a recognition of gain on the transfer of the asset, the basis of the asset in the hands of the shareholder is the asset’s fair market value. If the S corporation realizes a loss on the disposition of the asset, however, the loss is not recognized.³⁹

38. IRC Sec. 311(b).

39. IRC Sec. 311(a).

Because Subchapter S requires gain to be recognized on the disposition of property and Subchapter K does not, partnership taxation again holds advantages over S corporation taxation.

6. Special Taxes for S Corporations

In order to discourage abuse, Subchapter S imposes special taxes on S corporations. The built-in gains tax (BIG tax) is imposed on the sale of corporate assets within 10 years of the time when the corporation converted from a Subchapter C taxpayer to a Subchapter S taxpayer. The purpose of this tax is to prevent taxpayers from electing Subchapter S status simply to avoid a second-level tax on the sale of corporate assets. Furthermore, if the S corporation has excessive passive income, a special tax is imposed on the corporation at the corporate level, which, in essence, effectuates a reversion back to a double-tax system. Neither of these taxes is imposed on partnerships or LLCs.

7. Summary

The following table summarizes the major differences between Subchapter K and Subchapter S taxation:

Conclusion

Although LLCs are new entities, they are quickly taking center stage in the business planning arena. LLCs provide limited liability for all their members, enhanced creditor protection of business interests, and favorable tax treatment when compared to S corporations. While complex, the partnership tax rules are more flexible than the rigid requirements and extra taxes imbedded in Subchapter S of the Code. LLCs include all of the benefits of S corporations with few of the headaches or costs. Now that all 50 states have enacted LLC legislation, it is likely that there will be some effort to propose model legislation based on the newly enacted check-the-box regulations, which will help standardize the treatment of these vehicles across the states. The IRS, grudgingly, has recognized the validity of these entities and, by adopting the check-the-box regulations, has provided the catalyst for increased use of LLCs in the future. For new businesses, the LLC will almost always be preferable to the S corporation.

Recent regulatory and legislative enactments have made the S corporation rules more flexible, but these changes are probably too late to save the S corporation as a business entity. The 1995 and 1996 enhancements will certainly ease the burden for existing S corporations which find it too costly to liquidate, but will not be likely to encourage new businesses to elect Subchapter S status. The advent of the LLC and its growing acceptance has prompted some commentators to call for repeal of Subchapter S, allowing existing S corporations to become either LLCs or C corporations without penalty.⁴⁰ "When statutes that have outlived their usefulness remain on the books, they create inefficiencies that neither the country nor the economy needs."⁴¹ Perhaps Congress should consider enacting major reforms to the Code provisions dealing with S corporations instead of toying with minor changes that will impact fewer and fewer businesses as we move into the 21st century.

40. Walter D. Schwidetzky. "Is It Time to Give the S Corporation a Proper Burial?" Virginia Tax Review, Vol. 15, No. 4 (Spring 1996), p.593.

41. Schwidetzky, p. 651.

Where Can I Find Out More?

• GS 836 Business Succession Planning I. The American College.
• Walter D. Schwidetzky. "Is It Time to Give the S Corporation a Proper Burial?" Virginia Tax Review, Vol. 15, No. 4 (Spring 1996), pp. 593–651.

Interest Deduction Limitations for COLI
James F. Ivers III, Ted Kurlowicz, and Stephan R. Leimberg

What Was the Situation Before?

The Internal Revenue Service (IRS) has shown an increasing tendency to view interest deductions for company-owned life insurance (COLI) as abusive in certain cases. In 1995, the national office of the IRS requested information from all district and regional counsel attorneys regarding the deduction of interest payments on indebtedness incurred in connection with an insurance policy where a corporation is the policyowner and beneficiary.⁴² This notice stated that leveraged COLI—that is, policies purchased in part through borrowing against their cash values—"may present an abuse under Sec. 264."⁴³

^{42. IRS Notice N(35).}

^{43. IRC Sec. 264 covers the rules for the income tax deduction for the interest incurred on policy loans from a life insurance policy.}

COLI may take one of two forms.⁴⁴ A company may purchase insurance on the lives of its most valuable employees (key person coverage). However, when the company insures the lives of a large number of employees regardless of their compensation or relative value to the business (janitor insurance), the IRS has viewed COLI as a tax abuse.

44. Another valuable use of COLI not mentioned in Notice N(35) is coverage on the life of shareholders of a corporation to fund the corporation's obligation under a stock redemption agreement or redemptions prescribed under IRC Sec. 303.

What the notice clearly ignores is that regardless of which employees are insured, COLI serves a business purpose in that the policies will be used by the company to meet certain financial needs, such as post-retirement medical coverage. The perceived benefits of COLI plans include relatively low out-of-pocket after-tax costs and tax-free income to the company upon the death of an insured employee. In some cases, the amount of interest paid on the policy loan is only slightly less than the rate of return credited to the policy’s cash surrender value. Thus, the availability of an income tax deduction for interest paid on the policy loan might permit the corporation to profit on the tax-free buildup in the policy and receive a net cash influx as a result of the policy loan.

The IRS recognized that the business purpose for leveraged COLI may be valid. However, its position was that Sec. 264 was intended by Congress to prevent the financing of insurance purchases through tax benefits associated with the policy. Accordingly, the IRS examinations division was refusing to close cases involving COLI until formalized instructions on what specific grounds an interest deduction could be denied were issued from the national office.

What Is the Nature of the Change?

Congress enacted legislative changes related to the COLI issue in the Health Insurance Portability and Accountability Act of 1996.⁴⁵  These changes limit interest deductibility on COLI policies and can be summarized as follows:

• Policies Purchased before 6/21/86. These contracts are "grandfathered" for full interest deductibility based on rules in effect at that time. However, the interest rate that will be deductible is capped based on the applicable Moody’s interest rate (discussed later).
• "Key Person" Policies Purchased after 6/20/86. Policies that meet the definition of key person contracts are permitted interest deductibility (based on the Moody’s rate) for up to the first $50,000 of aggregate policy loans for COLI covering the life of a key person. Thus, COLI for (1) key-person coverage or (2) funding a stock-redemption agreement in a closely held corporation is largely unaffected.
• Policies Not Covering Key Persons
  • Purchased between 6/21/86 and 12/31/95. Transitional rules permit a phase-out of deductibility (based on the Moody’s rate) for up to the first $50,000 of aggregate policy loans for COLI covering the life of a nonkey employee. The deduction is limited to 100 percent for 1996, 90 percent for 1997, and 80 percent for 1998, with no deduction thereafter. (Note that the transitional relief does not apply if the number of insured individuals exceeds 20,000.)
  • Purchased after 12/31/95. Interest on such COLI is wholly nondeductible.

45. Health Insurance Portability and Accountablility Act of 1996, Sec. 501.

Basic Rule of Disallowance. Under the 1996 legislation, the basic rule for leveraged COLI is that no deduction will be allowed for interest paid on loans from company-owned life insurance, annuity, or endowment contracts that cover the life of an officer, employee, or other person financially interested in the business of the policyowner/taxpayer. The provision covers both incorporated and unincorporated businesses.⁴⁶

^{46. Thus, the new rules apply to insurance purchased by a partnership on a partner's life or by a limited liability company on a member's life.  Insurance on the life of a sole proprietor is treated as personally owned, and interest on such policy loans is treated under both Sec. 264 and 163 and is generally treated as personal interest.}

The "Key Person" Rule. The most significant exception to the basic rule of disallowance is the key person rule. This exception applies to interest that is not subject to either the grandfather rule or the transitional rules. Deductions under the key person rule are subject to the $50,000 of indebtedness per insured limitation. This exception preserves the interest deduction on the traditional COLI uses, such as key person coverage or stock-redemption funding.

Interest deductions are allowable under the key person rule if the "covered" person under a life insurance, annuity, or endowment contract is a "key person." What is a key person for purposes of the rule? First, the person must be either an "officer" or a "20 percent owner" of the business to be a key person.⁴⁷ A 20 percent owner is a person who owns 20 percent or more of the outstanding stock of the corporation, or one who owns stock possessing 20 percent or more of the voting power in the corporation. If the business is unincorporated, a 20 percent owner is a person who owns 20 percent or more of the capital or income interests in the business entity.⁴⁸

^{47. IRC Sec. 264(d)(3).}

^{48. IRC Sec. 264(d)(4).}

The number of persons who can qualify as key persons is limited by the new rules. That number cannot exceed 5 individuals unless the business has more than 100 total officers and employees.⁴⁹ If the business has more than 100 total officers and employees, then the total number of key persons cannot exceed the lesser of 5 percent of those officers and employees, or 20 individuals.⁵⁰ Therefore, the maximum number of key persons for any business is 20, and only businesses with officers and employees of 400 or more may have the maximum of 20 key persons.

49. IRC Sec. 264(d)(3)(A).

50. IRC Sec. 264(d)(3)(B).

New Limitation on Interest
Deduction For COLI

There is also a limitation on the interest rate that may be used in calculating allowable deductions under the key person rule. The maximum allowable interest rate is the lesser of the actual interest rate under the contract or the monthly Moody’s rate for the month the interest is paid or accrued.⁵¹

^{51. IRC Sec. 264(d)(2).}

Aggregation rules apply for purposes of determining who is the "taxpayer" (business) in calculating the maximum number of allowable key persons as well as for purposes of applying the $50,000 limitation.⁵² All members of a "controlled group" are treated as one taxpayer for these purposes. A controlled group includes all persons or entities treated as a single employer.⁵³

52. IRC Sec. 264(d)(5).

53. IRC Sec. 264(d)(5)(B). This includes those defined under IRC Sec. 52(a), Sec. 52(b), Sec. 414(m), and Sec. 414(o).

When Does the Change Take Effect?

The Grandfather Rule. The general rule does not apply to interest on loans from contracts issued before June 21, 1986.⁵⁴ This interest is generally deductible, and it is not subject to the $50,000 of indebtedness per insured limitation. However, there is a limitation on the interest rate that may be used in calculating deductions for interest payments under the grandfather rule.

54. IRC Sec. 264(a)(4).

For loans with fixed rates of interest, deductions are limited by the applicable "Moody’s Average" for the month in which the contract was purchased.⁵⁵ The Moody’s Average is a monthly corporate bond yield average published by Moody’s Investors Services, Inc.⁵⁶

^{55. IRC Sec. 264(d)(4)(1)(B)(ii)(I).}

^{56. As a practical matter, it may creat some compliance problems for the corporation to determine the appropriate rate. It is not known whether or not life insurance companies will pick up the burden of reporting the appropriate rate on such grandfathered policies.}

If a contract subject to the grandfather rules has a loan that carries a variable interest rate, the applicable limiting interest rate is calculated somewhat differently. The rate is the Moody’s rate for the third month before the first month in the "applicable period."⁵⁷ The applicable period is a period of months up to 12 months that is elected by the taxpayer owning the policy on the tax return for its first tax year ending on or after October 13, 1995.⁵⁸ Because of the timing of this rule, the tax return requiring the election of the applicable period has already have become due and may have been filed. If such a tax return has already been filed, it apparently must be amended to elect the applicable period. This period cannot be changed without IRS consent. The American Council on Life Insurance has asked the Treasury for guidance on the proper method for electing the applicable period.

57. IRC. Sec. 264(d)(4)(1)(B)(ii)(II).

58. IRC. Sec. 264(d)(4)(1)(B)(ii).

The Transitional ("Phase-in") Rules. These rules apply to two specifically defined types of indebtedness: indebtedness incurred before 1997 with respect to contracts entered into in 1994 or 1995, and indebtedness incurred before 1996 with respect to contracts issued before 1994.

Deductions for "qualified interest"⁵⁹ on indebtedness subject to the transitional rules are limited with respect to the interest rate that can be used in calculating the deductions. Deductions are calculated by the lesser of two rates: the borrowing rate specified in the contract as of October 13, 1995, or the "applicable percentage" of the Moody’s rate for the month the interest is paid or accrued.⁶⁰ The "applicable percentage" is 100 percent for 1996, 90 percent for 1997, and 80 percent for 1998.⁶¹ Interest paid or accrued after 1998 is not treated under the transitional rules. It is also important to note that interest can be deducted under the transitional rules only to the extent it would have been deductible prior to the 1996 legislation. For example, the $50,000 of indebtedness per insured limitation applies under the transitional rules.

59. Health Insurance Portability and Accountability Act of 1996, Sec. 501(c)(2)(B).

60. Health Insurance Portability and Accountability Act of 1996, Sec. 501(c)(2)(B)(ii).

61. Health Insurance Portability and Accountability Act of 1996, Sec. 501(c)(2)(C). It is not clear how the taxpayer should determine the applicable phase-out percentages when the interest is reported by the insurer on a calender or policy year that does not coincide with the corporation's fiscal year for tax purposes.  For a discussion of a reasonable accouting compliance method, see Bradley K. Walton, "Corporate-Owned Life Insurance Takes a Hit," Practical Accountant (January 1997).

"Qualified interest" under the transitional rules does not include interest paid or accrued after December 31, 1995, on borrowing by a taxpayer with respect to contracts on the lives of more than 20,000 persons.⁶² For this purpose, the aggregation rules described under the key person rules for determining when more than one entity may be treated as a single taxpayer also apply.⁶³ This provision prevents the continuation of tax avoidance in certain insurance placements, which have been referred to as "janitor insurance."

62. Health Insurance Portability and Accountability Act of 1996, Sec. 501(c)(2)(B)(i).

63. IRC Sec. 254(d)(5).

"Spreadforward" of Income From Affected Contracts. There is further relief for taxpayers who are facing the immediate nondeductibility⁶⁴ or the near-term phase-out of COLI interest deductibility.⁶⁵ If a taxpayer surrenders a contract affected by these new rules in 1996, 1997, or 1998, gain resulting from the surrender can be spread over 4 taxable years, starting with the year in which full recognition of gain would otherwise have occurred.⁶⁶ This treatment applies to any surrender, redemption, or maturity of any contract affected by the new rules. In addition, such a surrender will not cause the contract to fail the "four-out-of-seven" test or to be treated as a single-premium contract.⁶⁷

^{64. For example, taxpayers with COLI covering more than 20,000 individuals.}

^{65. Taxpayers with post - 6/20/1986 contracts covering 20,000 or fewer individuals.}

^{66. Health Insurance Portability and Accoutability Act of 1996, Sec. 501(d).}

^{67. IRC Sec. 264 (b).}

What Should Be Done?

Most closely held businesses will not be affected by these changes. Traditional uses of COLI, such as key person coverage or stock redemption funding, will probably qualify for the key person exception to the new rules; interest on such policies will continue to be deductible up to the first $50,000 of borrowing.

For taxpayers with COLI affected by the new law, some exit strategies could be suggested. First, policies on nonkey persons can be surrendered. The taxpayer may wish to wait until the end of 1998 to surrender the policies to take advantage of the continuing interest deduction during the phase-out

period.⁶⁸ With the partial deductions in 1997 and 1998, it may still be economically profitable to retain the COLI subject to the loans for the remainder of the transitional period.

68. Only applicable to tazpayers with COLI covering 20,000 or fewer individuals.

When the contracts are surrendered, this will not create a taxable event if no gain exists. If gain exists, the gain can be spread over 4 tax years, beginning with the year of disposition.

Where Can I Find Out More?

• HS 321 Income Taxation. The American College.
• IRC Sec. 264(d).

Chapter 2b

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