Martin was referring, of course, to IRC Sec. 1202, the exclusion for gain from certain small business stock, and one of its foremost interpreters, Tony Nitti, CPA, as Nitti spoke about Sec. 1202 and other selected business tax topics at AICPA & CIMA's ENGAGE 22 conference in Las Vegas.
We were extremely fortunate that Nitti generously shared a bit of his mastery on Sec. 1202, S corporations, and state passthrough entity (PTE) tax elections, in this podcast recorded June 8, a day before his ENGAGE presentation.
- Nitti, "Qualified Small Business Stock Gets More Attractive," The Tax Adviser (November 2018)
- Bell-Jacobs et al., "Where Individual, Corporate, and Passthrough Entity Taxation Meet," The Tax Adviser (June 2021)
- "States With Enacted or Proposed Pass-through Entity (PTE) Level Tax" (downloadable map)
- "State Implications With the PTE Tax" (Tax Section Odyssey podcast)
- "State Pass-through Entity-Level Tax Implementation Issues" (State Regulatory and Legislative Affairs paper)
What you'll learn from this episode:
- When and why an S corporation's governing provisions can matter more than its disproportionate distributions in avoiding an inadvertent termination of the S election.
- How to think about an inherent chicken-and-egg problem for PTE elections and SALT deductions.
- Although broader understandings may remain elusive, how recent IRS letter rulings and a Chief Counsel Advice memo have treated certain facts concerning trades or businesses in the fields of health and brokerage services for Sec. 1202 purposes.
Play the episode below or read the edited transcript:
— To comment on this episode or to suggest an idea for another episode, contact Paul Bonner at Paul.Bonner@aicpa-cima.com.
Paul Bonner: The AICPA & CIMA's ENGAGE 22 offers a wealth of learning, including, this year, a session by Tony Nitti, CPA, providing a general business update. Tony is a walking tax library himself, as a veteran tax practitioner, writer, and speaker par excellence, particularly on three timely topics he graciously previewed for us before his presentation to ENGAGE on June 9.
Tony is a national tax partner with EY Private in Denver. He leads the S corporation team of EY's National Tax Department, with a particular focus on Sec. 1202, the exclusion for gain from certain small business stock.
I'm Paul Bonner for the JofA. In today's podcast, Tony will discuss some recent developments in Sec. 1202, also S elections vis-à-vis the Sec. 1361(b)(1)(D) requirement that S corporations have no more than a single class of stock. And he'll address some issues of some states' passthrough entity, or PTE, tax election by which S corporations and partnerships may deduct on their federal returns state and local taxes paid at the entity level as a nonseparately stated item, without regard to the $10,000 so-called SALT cap, all right after a brief word from our sponsor:
Bonner: Thank you so much, Tony Nitti, for being with us today on the podcast. I know that you're at ENGAGE right now and are going be talking on this general business tax update topic. How's it going at ENGAGE by the way?
Tony Nitti: I just pulled in last night, and that would be Tuesday night. The conference started Monday, so I missed half the show. But it's always good to see some of the same faces, and, obviously, you have some top educators here giving their different classes. So I'm just getting rolling today. After my interview with you, I'm going to head over and see what tax topics are on the agenda today. But today's agenda, I think, is a little less tax-centric. Tomorrow is pretty heavy tax, so I'll probably be wall-to-wall sitting in on some sessions tomorrow. But ENGAGE — I think I've been here speaking seven or eight years now, so it's kind of a second home on the conference circuit.
Bonner: That's great. I know you're an S corporation specialist, and then there's this age-old question that is forever new, which is, what does it mean in Sec. 1361(b)(1)(D) when it says a small business corporation shall not have more than one class of stock? It makes it sound so easy, but it's not really, right?
Nitti: Yeah. That's something we're going to talk about tomorrow and certainly something that's become near and dear to my heart since I joined EY, running their Sub[chapter] S group, because EY certainly has its share of Sub S clients. But more often than not, what we have are clients who are acquiring Sub S clients.
So, depending on the nature of the transaction, they have a vested interest in making sure that that S election is valid, and so we have to run the gamut of all the different requirements. But to me, the S corp. eligibility requirement that tends to cause the most confusion around the industry is, as you said, the single-class-of-stock requirement. I'll explain why in a second.
But the motivation behind it makes total sense. When they enacted Sub S in 1958, they wanted to give a single level of taxation, like partnerships, but they didn't want that level of complexity. They didn't want substantial-economic-effect rules and special allocations and Sec. 704(c). They just wanted it to be really simple, pro rata, in accordance with stock ownership, and so, they said, the way we're going to do that is, we're just going to allow one class of stock, no preferred interests, nothing like that. So you can have one class of stock so that distributions are going to follow suit. Allocations of income will follow suit. You can have voting and nonvoting, but you can't have these multiple classes of stock. Like you said, it seems simple enough.
But where it really confuses people is, I think a lot of times in our industry, we interpret that to say any distributions that are [not] pro rata for even a moment in time are cataclysmic. They terminate the S election. That's just not the case. No. 1, just the regulations allow you to make disproportionate distributions, for example, when stock ownership is changing, because you might not distribute cash representing the previous year's income until after the year is closed, and maybe the ownership has changed.
If Paul and I were 50/50 shareholders last year, then we brought in someone new this year, but we want to distribute last year's income, we're allowed to distribute it 50/50 to Paul and I, even though there's the third shareholder. So some disproportionate distributions are allowed by regulation, but what really throws people off is, it's this interesting dichotomy. They say, to determine if you have a second class of stock, you've got to look at the governing provisions of the corporation, so the bylaws, the articles of incorporation, or as we'll talk about probably here, an operating agreement, if it's an LLC that checks the box to be a corporation.
Where things get confusing is, we tend to, as I said, think that even a momentary disproportionate distribution is cataclysmic, whereas the IRS has shown time and time again since the 1992 final regulations were issued, that what's not important is whether there's a disproportionate distribution. What's critical is whether those governing provisions of the corporation give every share of stock the same right to distribution of liquidation proceeds.
So where that becomes confusing is, you can have an S corporation that does everything wrong. I see these from time to time. They make disproportionate distributions when they shouldn't. But if the governing provisions give all the shares equal rights, the IRS is usually more than happy to give a pass and say, go ahead, correct the distributions, and we'll grant you inadvertent termination relief under [Sec.] 1362(f), if there even was a termination. But just go on about your business. You still have a good S corp.
But the opposite situation yields the opposite result. If you have a corporation that does everything right, makes all the distributions pro rata, but the underlying governing documents confer different rights to distribution and liquidation proceeds, that is cataclysmic. You do have a bad S election.
Since the 1992 regs. were passed, they really almost make it difficult to create a second class of stock. But where we're seeing it happen time and time again is in the arena of state-law LLCs that use the check-the-box regs. at [Regs. Sec.] 301.7701-3 to simultaneously make a deemed corporation election and also an S election. What these LLCs forget to realize is, they've got an LLC agreement. That LLC agreement is a governing provision of the S corporation, and in all likelihood, that LLC agreement is going to have your standard partnership language in it, your [Sec.] 704(b) allocations, your [Sec.] 704(c) allocations, your substantial-economic-effect rules. All of those create a second class of stock by definition.
So I am certain, Paul, that we just have a ton of purported S corporations running around out there around America that are not good S's right now because they're LLCs for state law, and no one has taken a look at the underlying agreement and realized that that basic boilerplate language actually keeps them from having a good S.
That's really the first ruling that we're going to get into tomorrow, just a reminder for everybody in attendance that if you've got an LLC that checks the box, you better read these operating agreements, because you probably don't have an S corp. client.
Bonner: What's the ruling in particular?
Nitti: The one we're going to look at tomorrow actually sneaks back into 2021, even though I like to keep this all within 2022. It's [IRS Letter Ruling] 202110010. It's an interesting ruling, but I could have picked any one of half a dozen from the last eight or nine months. They were coming out of this point maybe once every two or three weeks. So there's plenty of reason to be concerned.
But when this happens, [Sec.] 1362(f) gives you a bailout. It's not a cheap bailout, but you can go in for a private letter ruling and say, whoops, we didn't realize we had bad governing provisions; we're going to fix it. Can you basically give us a pass and say that we've been a good S all along? And the IRS is more than happy to do that.
Bonner: OK. There is a silver lining, isn't there?
Bonner: I was intrigued when you mentioned earlier passthrough entity taxes because that was a real flurry of concern about six months ago at the end of 2021 when people were realizing, I think, that Notice 2020-75 means what it says, that it applies to SALT PTE taxes paid during the tax year, notwithstanding that some of those calculations would happen as those returns are being filed in the subsequent calendar year. People realized, we'd better make those tax payments in 2021. Or were they overly cautious?
Nitti: No. Notice 2020-75, like you said, it just comes out and grants this deduction but seems to ignore the general requirements for deduction under the [Regs. Sec. 1.]461-4 regulations.
I think it's right to be concerned here, particularly for accrual-method taxpayers who are in a state like California, for example, where the election is not made until the filing of the return in the following year, because we know, under [Regs. Sec.] 1.461-4, there's three requirements for an accrual-method taxpayer to get a deduction. First and foremost, the liability has to be fixed at the end of the year. Second, you have to be able to determine it with reasonable accuracy, and then economic performance has to occur. For taxes, economic performance occurs as it's paid, and we can use the recurring-item exception of the dash-five regs. under [Sec.] 461 for that. But who cares about economic performance, because how does one argue that you can deduct a liability in a given year when it hasn't been fixed by the end of that year because you have not made the election, at the time the year is over, to enter into the PTE election?
So that's where we've got this notice that just glosses over rules that have long preexisted Notice 2020-75. I do think that something we have to wonder about is for some states, like California, how can we argue we have a good deduction for liability at the end of the year when it's going to be a couple of months before we opt into the PTE program to begin with and essentially fix that liability?
Paul, between you and I, that's one of probably five or half a dozen PTE issues I'm going to discuss tomorrow because there's more questions than answers at this point.
Bonner: I guess so. One of them being, what will those proposed regs. say that the notice promised? They're not out yet.
Nitti: There's going to be quite a bit of activity. I know that what we're really curious about is the interplay between the PTE and, actually, the rules that you just talked about, Sub S single class of stock. What happens if you've got an S corporation with two 50/50 shareholders, but one of them is not a resident of the state, one of them is, so they end up paying different PTE amounts? How do you justify allocating the PTE deduction at the entity level disproportionately between the two members, even though they're 50/50 shareholders? But that's what would be required to be done. Both the deduction and the credit would need to be allocated in accordance with what the shareholders paid, even though they are 50/50 shareholders.
So we're really going to need a lot of guidance on the interplay between the PTE regimes and the single-class-of-stock S corp. rules, because what if someone can opt in at the shareholder level to the PTE? So to balance it out, the S corp. makes a distribution to one shareholder and instead pays the PTE on behalf of the other shareholder. Now you've got disproportionate distribution to deal with as well. Is that going to catastrophically potentially terminate your S election? We just said earlier today it shouldn't, but nobody is going to feel good about making disproportionate distributions when they've been trained all along to think that's a no-no in S corp. world.
Bonner: What a can of worms that will be! I want to move on to one thing that we talked about a little bit a few days go by email that I find intriguing, which is Sec. 1202, and particularly some of the PLRs we've seen coming out dealing with what is a qualified trade or business for purposes of [Sec.] 1202(e)(3). As we talked about, in the field of health, there are some that seem very much wider than the fairly restrictive one that came out in January this year on brokerage services. But they seem to me very different in their analysis, very different in their conclusions. What do you think?
Nitti: This has been an interesting roller coaster ride that we've been on. But this is where we start at EY all of our [Sec.] 1202 analysis. Before we get into any of the math, we say, are we in a good business? There's no clear way to answer that; it's hard to know
We know what fields are disqualified — health, law, consulting, and actuarial science, and brokerage, engineering, and those sorts of things, but we don't know what they mean.
Now, since 2014, we've gotten maybe three or four rulings on health, one previous one on brokerage, so we've gotten a little bit of insight. But what happened is, in 2018, when they passed the Tax Cuts and Jobs Act and enacted [Sec.] 199A, 199A leveraged off [Sec.] 1202(e)(3), and it stole most of those disqualified fields and then it defined them. We got detailed regulations, something we've never gotten under [Sec.] 1202. We got these detailed regulations that went to great pains to tell us what it means to be in the field of health or law or actuarial science.
From that point, we assumed, when the IRS has to make this determination under [Sec.] 1202 whether someone's in a good business, they'll just leverage off [Sec.] 199A, maybe a little bit under [Sec.] 448, and they'll go from there. What was eye-opening about the CCA [Chief Counsel Advice] you referenced, 202204007, I believe —
Bonner: Yes. That's right.
Nitti: — is No. 1, it was the first adverse CCA or private letter ruling about [Sec.] 1202. But really, what made it significant is, they said, no, no, no, we are going to distinguish [Sec.] 199A here entirely, because the point of [Sec.] 199A was to pass out a lot of deductions to passthrough owners to make them whole for the drop in the C corporation rates, so we want this to be abundant. And because we want the [Sec.] 199A deduction to be abundant, we want these disqualified fields to be interpreted very narrowly. For example, a broker for [Sec.] 199A purposes is limited to someone who arranges between a buyer and a seller of securities under the meaning of [Sec.] 475.
They could have just adopted that same philosophy for [Sec.] 1202. But they said, [Sec.] 1202 is a very generous exclusion provision. As a result, we are required to interpret that exclusion narrowly, which means we have to interpret these disqualified fields extremely broad. They said, we're going to just forget about [Sec.] 199A. We're going to peruse the statute and look for the most broad definition we have of a broker.
The company that was at the heart of CCA 202204007 was an Airbnb-type company, somebody who just hosts a website that lists property for rent. Then people can come on and, basically, peruse the listings, decide which one they want, and the company would get paid both a hosting fee as well as a percentage of the rents. They specifically said on their website, we're not a licensed broker; none of this is binding. Anything you do, we can't bind the two of you. You have to separately work it out. We're just providing the avenue to find these landlords.
They could have said, this isn't a security under [Sec.] 475, so you're not a broker. That's what [Sec.] 199A said. They said, no, no, no, we're going to look elsewhere. We're going to look at the plain meaning of what it means to broker. We're going to look at the Sec. 6045 definition of a broker. Basically, at its highest level, a broker is someone who acts as a middleman between two parties that are exchanging goods or services.
Bonner: An intermediary, yeah.
Nitti: Yeah, an intermediary, and they said, case closed. That definitely shocked our little world a little bit in the [Sec.] 1202 space, because we said, everything we've learned under [Sec.] 199A — and we've learned a lot — is effectively useless for us. So we're back to just going, who knows?
But this is the first time where the IRS has come out and said, we're going to interpret this very broadly, these disqualified fields, and that gives us reason to be concerned.
There was a previous PLR issued in 2021 on brokerage, and the citation escapes me now, but it was an insurance broker who was a broker in the truest sense of the word, but they provided some ancillary services. They had to report any accidents. They had to keep administrative records. The IRS said that wasn't a disqualified field of brokerage, and I think maybe they got a little bit concerned that that was too generous an interpretation, because this came down in the form of a CCA where they were alerting their internal people that this is our new take on it.
But then what happened a week ago on Friday, or I guess two weeks ago Friday, now, we're going to test citations again, but I think it's 202221006.
Nitti: All right, I'm doing all right, Paul. That's the one where, I don't know, same exact author as [CCA] 202204007, and it was a pharmacy, basically. They employed licensed pharmacists, but they sold products, and so on the surface, it doesn't seem like a service business. It would certainly line up with the previous ruling from 2014 where that type of business was blessed for [Sec.] 1202 purposes.
But it's interesting. Pharmacies have always been interesting under [Sec.] 199A because a pharmacy itself is not a disqualified business, but the business of being a pharmacist is. If you own a pharmacy, you can take the [Sec.] 199A deduction, presumably. If you are a pharmacist who's an independent contractor, you certainly cannot.
Here we had a pharmacy that had licensed pharmacists there who would fill the prescription and assist the customers and whatever it may be. But they could have taken just as an expansive view as they did in the previous CCA. But instead, the IRS almost took a narrower view than even maybe [Sec.] 199A would necessarily take. They say, you're not diagnosing or treating a disease. You're not dealing directly with the patients, so you're not in the field of health. To me that sounds like [Sec.] 199A-type language. That's what [Sec.] 199A says. It limits the field of health to those that are working directly with providing medical services directly to a patient.
Not that I'm saying that this PLR was wrong, because it's welcome news, certainly, for taxpayers, but it's a little bit of a surprise coming on the heels of [CCA] 202204007, where we thought they were going to take this much more stringent view of these disqualified fields. Instead, they throw us what I think is a very favorable ruling. Just more confusion, Paul, more confusion thrown into an already confusing area of the law.
Bonner: A little leeway for health is always good, I suppose, maybe. I don't know. What do you think?
Nitti: Yeah, that's a good point. Maybe it really will come down to a field-by-field type distinction. I work in the [Sec.] 1202 space all the time, and it never ceases to amaze you how many business models you could easily argue both sides of the fence from a [Sec.] 1202 perspective.
One of the things, too, that was fascinating about the 202204007 CCA is at the very end. It was almost like a throwaway sentence, but they said the fact that the services were not provided by an individual but rather by software created by an individual does not change the result. That's a bit scary because I think most around the industry have taken the position that software as a service has been OK from a [Sec.] 1202 perspective. What that language says to me is that you almost have to ignore the software and say, if the same services that are being provided by the software were being provided by an individual, would we have a problem?
Sometimes that may change your analysis a little bit. I think that's something we need to take note of going forward as well. I do think some people have taken a blanket view that software as a service tends to be fine from a [Sec.] 1202 perspective, but I think we have to ask, what is the software doing? And if it's doing something that, had it been done by an individual directly, it would have been problematic, maybe we shouldn't get a different result because it's being done via software.
Bonner: Great. Final thoughts?
Nitti: The final thoughts are, I think the most fascinating thing about giving a business tax update at ENGAGE right now isn't anything we're going to be talking about. It's what we're not going to be talking about.
Nitti: I don't think anybody could have imagined, by summer of 2022, that we wouldn't be unpacking the latest regulatory guidance interpreting the Tax Reform Act of 2021, right? We thought we were going to have an overhaul of the tax law when the Democrats took control of the White House, House, and Senate in January of 2021. It's funny to come into these updates and, yeah, it's like an old-fashioned update, Paul. We're just talking about private letter rulings and cases and not unpacking 500 pages of [Sec.] 163(j) regulations or 400 pages of [Sec.] 199A regulations, and that was a very realistic possibility. Had a Build Back agenda been passed, we might very well have been doing that.
But even with the reconciliation package, we all know that they weren't able to get anything passed, at least not yet. It's just, to me, that's the headline, I would have thought when the AICPA asked me to do a business tax update in summer of 2022, we'd be interpreting a huge legislative package, and that just never came to fruition. So it means, around the industry, we get to take a well-deserved deep breath and just go back to an old-fashioned update. I'm looking forward to it.
Bonner: Or a little saner, maybe you could say.
Nitti: Yes, exactly.
Bonner: Thank you so much, Tony. We really appreciate your giving this insight into these issues of a business tax update. Thank you so much.
Nitti: Anytime, Paul. Like I said, I think ENGAGE is one of the first conferences that ever invited me to speak, and so I'll keep coming back as long as you'll have me.
Bonner: Great. Appreciate it.