Senate Bill 5 (Lockyer), as enacted on October 3, 1997, made the following changes to California law:
SUBJECT: Federal Conformity-S Corporation and Exclusion of Gain from Sale of Principal Residence
Unless otherwise stated the provisions, of this act are effective for taxable and income years beginning on or after January 1, 1997.
Section 17152 of the Revenue and Taxation Code is amended.
Exclusion of Gain from the Sale of a Principal Residence (IRC §121)
This act conforms to the Taxpayer Relief Act (TRA) of 1997 (P.L. 105-34) provision which excludes gain from sale of principal residence. This act conforms for sales of principal residences occurring on or after May 7, 1997, and before July 1, 1998.
A taxpayer generally is able to exclude up to $250,000 ($500,000 if married filing a joint return) of gain realized on the sale or exchange of a principal residence. The exclusion is allowed each time a taxpayer selling a principal residence meets certain eligibility requirements, but generally no more frequently than once every two years (sales occurring before May 7, 1997, are not considered for the two-year rule). The law provides that gain would be recognized to the extent of any depreciation allowable with respect to the rental or business use of such principal residence for periods after May 6, 1997. To be eligible for the exclusion, a taxpayer must have owned the residence and occupied it as a principal residence for at least two of the five years prior to the sale or exchange.
The federal House, Senate and Joint Committee Reports on the TRA state a taxpayer who fails to meet these requirements (use for two out of the last five years and no sale within two years of another sale) by reason of a change of place of employment, health, or other unforeseen circumstances is able to exclude the fraction of the $250,000 ($500,000 if married filing a joint return) equal to the fraction of two years that these requirements are met. This proration rule is also available for any sale occurring within the two-year period following enactment of this provision. However, the law as enacted provides the fraction of the taxpayer’s realized gain on the sale equal to the fraction of two years that the requirements are met is excludable
In the case of joint filers not sharing a principal residence, an exclusion of $250,000 is available on a qualifying sale of the principal residence of one of the spouses. Similarly, if a single taxpayer who is otherwise eligible for an exclusion marries someone who has used the exclusion within the two years prior to the marriage, the couple would be allowed a maximum exclusion of $250,000. Once both spouses satisfy the eligibility rules and two years have passed since the last exclusion was allowed to either, the taxpayers may exclude $500,000 of gain on their joint return. Federal law also contains special rules regarding: sale of a remainder interest, cooperative housing corporations (e.g., condominiums), involuntary conversions, and taxpayers residing in nursing homes.
Under federal law, the TRA repealed provisions of the Internal Revenue Code regarding the once-in-a-lifetime exclusion of $125,000 and the rollover of gain from the sale of a principal residence. The TRA also modified the reporting requirements of brokers for the sale of the broker’s clients principal residences.
For the sale of a taxpayer’s principal residence occurring on or after May 7, 1997, and on or before June 30, 1998, this act conforms California law to federal law as it relates to the exclusion of gain from the sale of a principal residence and the reporting of real estate transactions. SB 1233 (Stat. 1997, Ch. 612) contains provisions that conform California law to federal law as it relates to the exclusion of gain from the sale of a principal residence effective for sales occurring on and after July 1, 1998 (the date this provision becomes inoperative regarding the exclusion for gain from the sale of a principal residence exclusion).
Section 17275.6 is added to the Revenue and Taxation Code.
Charitable Contribution of S Corporation Stock (IRC §170(e))
In the case of a charitable contribution of S corporation stock, this act states that rules similar to those used in IRC §751 shall be used to determine whether the gain on the S corporation stock (had it been sold at its fair market value) would have been long-term capital gain or ordinary income. The ordinary income portion is excluded from the contribution amount. If the contribution was made to certain private foundations, the amount of capital gain is also excluded from the contribution amount. This provision conforms to federal law and is effective for taxable years beginning on or after January 1, 1998.
Section 17731.5 is added to the Revenue and Taxation Code.
Taxation of Electing Small Business Trusts (IRC §641)
This provision provides how an "electing small business trust" (ESBT), which may hold stock in a S corporation (see §23800.5 of this change report), is taxed. The portion of the ESBT which consists of stock in one or more S corporations is treated as a separate trust for purposes of computing the income tax attributable to the S corporation stock held by the ESBT. The ESBT is taxed at the highest individual rate (currently 9.3%) on this portion of the ESBT’s income. This provision conforms to federal law.
Section 18037.5 is added to the Revenue and Taxation Code.
Cross References for the Exclusion of Gain from the Sale of a Principal Residence
For sales of principal residences occurring after May 6, 1997, and on or before June 30, 1998, this provision provides that various references to IRC §1034 in the Personal Income Tax Law (PITL) and the IRC are changed to refer to §17152. This provision also states that for PITL §17152, the resale of a repossessed principal residence shall not be treated as a part of the transaction constituting the original sale, if IRC §1038(a) applies and the principal residence is resold within one year. This provision also provides that depreciation recapture determined under IRC §1250 shall not apply to a sale of a principal residence (PITL §17152 provides that all gain due to depreciation from a sale of a principal residence is recognized). These changes conform to current federal law as it relates to the sale of a personal residence. SB 1233 makes the same changes for sales or exchanges of principal residences occurring on or after July 1, 1998.
Section 18042 (and §24954) of the Revenue and Taxation Code is amended.
Sale of Stock to Employee Stock Ownership Plans (IRC §1042)
Generally, no gain is recognized if 1) qualified securities are sold to an Employee Stock Ownership Plan (ESOP), 2) the ESOP owns 30% of the total outstanding value of the stock of the corporation after the sale, 3) the taxpayer files a written statement with the IRS and/or Franchise Tax Board (FTB), and 4) the taxpayer replaces the "qualified securities" sold within 12 months of the sale. Prior to the passage of this act, "qualified securities" was defined as securities issued by a "domestic corporation" that are not readily tradable on an established securities market. This provision changed "domestic corporation" to "domestic C corporation," thus making S corporation securities ineligible. This provision conforms to federal law.
Section 18510 of the Revenue and Taxation Code is amended.
For Filing Requirement Purposes Gross Income Includes Exclusion from Sale of Principal Residence
This provision changes the cross reference of R&TC §§18501, 18505 and 18521 from IRC §121 to PITL §17152. This provision states that in determining if a taxpayer has a filing requirement, gain realized from the sale of a principal residence shall be considered in computing gross income.
Section 18601 of the Revenue and Taxation Code is amended.
Shareholder Reporting is Required to be Consistent with S Corporation Reporting (IRC §6037(c))
This provision requires that an S corporation provide to each shareholder a copy of the information shown on the S corporation’s return. Additionally, this provision requires that a shareholder’s tax return must be consistent with the S corporation’s return. The shareholder may file inconsistently if a statement is attached to the return identifying the inconsistency. If the shareholder does not inform the FTB of the inconsistency, the FTB may treat the inconsistency on the shareholder’s return as a mathematical or clerical error and assess accordingly. Penalties may be imposed upon a shareholder for not being consistent with the S corporation return.
Section 19136.4 is added to the Revenue and Taxation Code.
Waiver of Estimated Tax Penalty
This provision waives the estimated tax penalty if the underpayment was created or caused by the exclusion of gain from the sale of a principal residence provisions of this act (gain from the sale of the principal residence exceeds the exclusion amount). This waiver only applies to 1997 estimated payments made before April 16, 1998.
Section 19365 is added to the Revenue and Taxation Code.
Transfer of Estimated Tax payments from the S Corporation Account to the Shareholder’s Account
This provision provides transitional relief for C corporations electing to be an S corporation for income years beginning in 1997. The electing corporation is allowed to file an application to have part of the estimated tax payment transferred to the personal income tax accounts of its shareholders. The application must be for the transfer of at least $500. The corporation must file an application with the FTB setting forth: (1) the amount the S corporation estimates as its tax liability, (2) the amount and date of each estimated tax payment made prior to the application, and (3) for each affected shareholder, the shareholder’s name, social security number, address, percent of ownership, amount of each overpayment to be transferred and the date of the payment. Within 45 days of receiving the application, the FTB is required to make a determination regarding the transfer. The corporation is required to furnish a statement to all shareholders disclosing the amounts and dates of the transfers being made to their personal income tax accounts.
Section 23732 of the Revenue and Taxation Code is amended.
Exempt Organization Income from a S Corporation Is Unrelated Business Income (IRC §512(e))
Items of income or loss of an S corporation flow through to qualified tax-exempt shareholders (see §23800.5 below) as unrelated business taxable income (UBTI), regardless of the source or nature of such income (e.g., passive income of an S corporation will flow through to the qualified tax-exempt shareholders as UBTI). In addition, gain or loss on the sale or other disposition of stock of an S corporation by a qualified tax-exempt shareholder is treated as UBTI.
A qualified tax-exempt shareholder that purchases stock in an S corporation (whether such stock was acquired when the corporation was a C or an S corporation) and receives a dividend distribution from the S corporation (i.e., a distribution of Subchapter C earnings and profits), except as provided in regulations, must reduce its basis in the stock by the amount of the dividend.
Section 23800.5 is added to the Revenue and Taxation Code.
Qualified Shareholders of an S Corporation (IRC §1361)
This provision conforms to seven Small Business Job Protection Act (SBJPA) changes made to federal S corporation law:
- Increases the number of shareholders an S corporation may have from 35 to 75.
- Provides that effective for income years beginning on or after January 1, 1998, qualified tax-exempt organizations may be shareholders in S corporations. For purposes of determining the number of shareholders of an S corporation, a qualified tax-exempt organization will count as one shareholder. Qualified retirement plan trusts and certain charitable organizations may be qualified shareholders of an S corporation.
- Provides that a grantor trust may hold S corporation stock for two years (previously 60 days) from the date of the grantor’s death. Similarly, testamentary trusts also may hold S corporation stock for two years beginning with the date the stock was transferred to the trust.
- Allows Electing Small Business Trusts (ESBT) to be shareholders in an S corporation. In order to qualify as an ESBT, all beneficiaries of the trust must be individuals or estates eligible to be S corporation shareholders, except that charitable organizations may hold contingent remainder interests. No interest in the ESBT may be acquired by purchase. For this purpose, "purchase" means any acquisition of property with a cost basis. Thus, interests in the ESBT must be acquired by reason of gift, bequest, etc. A trust must elect to be treated as an ESBT.
- Each potential current beneficiary of the ESBT is counted as one shareholder for purposes of the 75 shareholder limitation (or if there were no potential current beneficiaries, the ESBT would be treated as the shareholder). A potential current income beneficiary means any person, with respect to the applicable period, who is entitled to, or at the discretion of any person may receive, a distribution from the principal or income of the ESBT.
- The portion of the ESBT which consists of stock in one or more S corporations is treated as a separate trust for purposes of computing the income tax attributable to the S corporation stock held by the ESBT.
- Allows an S corporation to own 100% of the stock of a C corporation.
- In addition, an S corporation is allowed to own a qualified Subchapter S subsidiary (QSSS). A QSSS is a domestic corporation that: (1) is not an ineligible corporation (i.e., a corporation that would be eligible to be an S corporation if the stock of the corporation were held directly by the shareholders of its parent S corporation), (2) 100% of the stock of the subsidiary is held by its S corporation parent, and (3) the parent elects to treat the subsidiary as a QSSS (the election of QSSS treatment for federal purposes is treated as an election for state purposes, unless the parent itself elects to be treated as a C corporation for state purposes). Under the election, the QSSS is not treated as a separate corporation, and all assets, liabilities, and items of income, deduction, and credit of the subsidiary are treated as the assets, liabilities, and items of income, deduction, and credit of the parent S corporation.
- Additionally, this provision provides that the activities of the QSSS would be treated as activities of the parent S corporation. The QSSS is subject to a tax of $800 annually. The QSSS tax is assessed annually on the QSSS; however, the liability to pay the tax becomes the liability of the parent S corporation.
- Allows a bank to be an S corporation unless such institution uses a reserve method of accounting for bad debts. Prior law disallowed S corporation status if a financial institution was eligible to use the reserve method for bad debts. The bad debt reserve method is a moving average based on the historical performance of the taxpayer or taxpayer’s industry.
- S corporations may have only one class of stock. In some circumstances, debt can be considered equity (stock) and even a second class of stock. This provision provides safe harbor rules denoting that certain "straight debt" shall not be treated as a second class of stock. Straight debt is defined as any written unconditional promise to pay a certain sum of money on demand or on a specified date. The debt instrument also must meet certain other requirements: the interest rate or payment dates are not contingent on profits, the borrower’s direction, or similar factors; the debt cannot be converted into stock; and the creditor is an individual (other than a nonresident), an estate, a trust or person regularly in the business of lending money (a person is defined as any legal entity).
Section 23801 of the Revenue and Taxation Code is amended.
Invalid Elections and Inadvertent Terminations (IRC §1362)
This provision conforms California law with the federal law allowing the correction of invalid elections. Under this act, the FTB will allow an S corporation to correct an invalid or late election for income years beginning on or after January 1, 1997, in specified circumstances as provided in current federal law. Federal law provides that if the Secretary determines an S corporation inadvertently made an invalid S corporation election or inadvertently terminates its S corporation election, the corporation shall be treated as an S corporation for the period specified by the Secretary. Invalid elections that qualify for a determination are those due to: (1) elections received by the Secretary more than 2½ months after the start of the corporation’s tax year to which the election applies, (2) the corporation did not meet the definition of a "small business corporation" on the date the election was filed, and (3) the corporation did not obtain the consent of all shareholders by the date the election was filed. Inadvertent termination are limited to terminations due to: (1) a corporation which ceased to be a small business corporation or (2) a corporation’s passive investment income exceeded 25% of the corporation’s gross receipts for three consecutive taxable years and has C corporation earnings and profits. Other stipulations under the inadvertent rules require, where applicable, the correction of the cause of the termination or invalid election and the making of any adjustments consistent with the treatment as an S corporation for the period being allowed to be an S corporation by the Secretary. All shareholders and the corporation must agree to the adjustments. The act also provides that if a federal determination is made regarding an invalid election, allowing the taxpayer to be an S corporation for federal purposes prior to January 1, 1997, the corporation is automatically considered to be an S corporation for state purposes for its first income year beginning after December 31, 1996. The corporation still will be able to revoke its S corporation election under existing provisions in the law. Under a transitional clause, the time allowed to revoke its S election is extended by the act to the date which is 180 days after the date of enactment (4/28/98).
This provision also provides that if an S election was terminated in a taxable year beginning before January 1, 1997, the corporation may immediately file an election for S corporation status without the consent of the Secretary. If an S election was terminated in a taxable year beginning after December 31, 1996, the corporation must wait five taxable years to re-elect S corporation status.
This provision additionally provides that dividends received by an S corporation from a C corporation owned 80% or more by the S corporation are not treated as passive investment income (which may terminate the S election) to the extent the dividends are attributable to the earnings and profits of the C corporation derived from the active conduct of a trade or business. Dividends received from a C corporation, in which the S corporation owns less than 80% of the stock, are considered passive investment income.
Section 23802 of the Revenue and Taxation Code is amended.
S Corporation Tax Rate Increase
This provision increases the tax rate imposed on S corporations from 1.5%. This act would have increased the rate for income years beginning on or after January 1, 1997, as follows: 1997 - 1.6%; 1998 - 1.65%; 1999 - 1.7%; 2000 and thereafter - 1.6%. However, SB 1233 chaptered out this provision. The tax rate remains 1.5% for all years.
Section 23802.5 is added to the Revenue and Taxation Code.
Items of Income, Loss and Suspended Losses (IRC §1366)
This provision provides that a shareholder trust or estate that terminates before the end of the S corporation tax year will account for its pro rata share of income and loss items as a deceased individual. This is a conforming amendment due to various changes made by this act.
This provision also permits losses that are not deductible in one taxable year because of the at-risk rules to be carried forward to the S corporation’s post-termination transition period. Losses carried over are deductible to the extent stock basis and at-risk basis have increased during the corporation’s post-termination transition period.
Section 23804 is added to the Revenue and Taxation Code.
Treatment of Inherited Stock (IRC §1367)
A person acquiring stock in an S corporation from a decedent must treat as income in respect of a decedent (IRD) that person’s pro rata share of any item of income of the corporation that would have been IRD if acquired directly from the decedent. If an IRD is included in the value of the decedent’s estate, a deduction for the estate tax attributable to the IRD item generally is allowed to the person (estate or individual) reporting the IRD. The stepped-up basis in the stock in an S corporation acquired from the decedent is reduced by the extent to which the value of the stock is attributable to items consisting of IRD.
This provision codifies FTB’s current practice of determining the basis of inherited stock and conforms California to present federal law.
Section 23804.5 is added to the Revenue and Taxation Code.
Treatment of Distributions During Loss Years (IRC §1366)
Distributions from an S corporation are nontaxable to the extent of the adjusted basis of the shareholder’s stock. The adjusted basis is reduced by the distribution. Distributions in excess of basis are treated as gain from the sale or exchange of property. If an S corporation has accumulated earnings and profits, any distribution in excess of the amount in the accumulated adjustment account (AAA) will be treated as a dividend (to the extent of accumulated earnings and profits). A dividend distribution does not reduce the adjusted basis of the stock. An AAA is the amount of the accumulated undistributed post-1982 (post-1986 for California) gross income less deductions.
For purposes of determining the treatment of distributions made during a taxable year by an S corporation with accumulated earnings and profits, net negative adjustments (i.e., the excess of losses and deductions over income) for the taxable year of the distribution are disregarded in determining the amount in the AAA.
The order of the adjustments made to the AAA differs between a net gain year and a net loss year, as explained below.
A. Net Gain Year
If the aggregate pass-through income and gain items exceed the aggregate pass-through loss and deduction items, the AAA is adjusted in the same order as the stock basis above, namely: (1) increased by pass-through items of income and gain, (2) decreased by distributions, and (3) decreased by pass-through items of loss and deduction.
B. Net Loss Year
If the aggregate loss and deduction items exceed the income and gain items, distributions are taken into account first, which reduces the likelihood that the distribution will be taxable. For net loss years, the AAA beginning balance is: (1) decreased (but not below zero) by distributions, (2) increased by pass-through items of income and gain, and (3) decreased by pass-through loss and deduction items. A distribution will only be taxable if the AAA is reduced below zero after the distribution adjustment.
This act conforms California law to federal law regarding the order in which adjustments are to be made in determining stock basis and the AAA. Distributions would be taken into account before pass-through items of deduction or loss.
Section 23806 of the Revenue and Taxation Code is amended.
Treatment of S Corporation Under Subchapter C Rules (IRC §1371)
This act provides for purposes of the application of Subchapter C rules, an S corporation, in its capacity as a shareholder of another corporation, is treated as a corporation. This allows the liquidation of a C corporation into an S corporation to be governed by the generally applicable Subchapter C rules, including rules allowing the tax-free liquidation of a subsidiary into its parent corporation. Following a tax-free liquidation, the built-in gains of the liquidating corporation may later be subject to tax upon a subsequent disposition. An S corporation also is eligible to make an election to treat certain stock purchases as asset acquisitions provided certain other requirements are otherwise met. This results in immediate recognition of all the acquired C corporation's gains and losses (and the resulting imposition of a tax) and the benefit of a stepped-up basis in the assets acquired. This provision also provides that an asset acquisition election made for federal purposes will be treated as an election for state purposes. The corporation cannot file a separate state election.
Section 23813 is added to the Revenue and Taxation Code.
Agreement to Terminate Year and Expansion of the Post-Termination Period (IRC §1377)
The act provides that if an S corporation shareholder's entire interest in the corporation is disposed of, the S corporation can elect to close its year with respect to that shareholder and to allocate the pass-through items as if the year consisted of two tax years. A "specific accounting method" allocation is accomplished by "closing" the corporation's books as of the day a shareholder’s ownership interest terminated. This allocation is based on normal accounting rules, using the company's books and records for each respective period.
The S corporation can elect to use the specific accounting method if all the shareholders affected by the stock disposition consent. The shareholders affected by the stock disposition includes the shareholder whose interest is terminated and all shareholders who acquired shares from the terminating shareholder during the tax year. If the shares were transferred to the corporation, all shareholders who owned stock during the year are affected shareholders. This is a change from the requirement for all shareholders (affected or not) to consent to allow for a specific accounting method and the closing of the books.
Additionally, this provision expands the post determination period to include a 120-day period beginning on the date of any determination pursuant to an audit of the taxpayer that follows the termination of the S corporation's election and that adjusts a Subchapter S item of income, loss or deduction of the S corporation during the S period. The definition of "determination" includes a final disposition by the Secretary of the Treasury, a final decision by the State Board of Equalization or a closing agreement.
Section 24611 of the Revenue and Taxation Code is amended.
Certain Benefits Not Applicable to S Corporations (IRC §404)
This provision states that an S corporation may not deduct certain dividends paid to an certain employee trusts, annuity plans or other deferred compensation plans. This provision also does not allow deductions for certain principal and interest payments made to certain employee stock ownership plans. Both of these items are allowed to C corporations.
Section 24954 (and §18042) is added to the Revenue and Taxation Code.
Sale of Stock to Employee Stock Ownership Plans (IRC §1042)
Generally, no gain is recognized if: 1) qualified securities are sold to a Employee Stock Ownership Plans (ESOPs), 2) the ESOP owns 30% of the total outstanding value of the stock of the corporation after the sale, 3) the taxpayer files a written statement with the IRS and/or FTB, and 4) the taxpayer replaces the "qualified securities" sold within 12 months of the sale. Prior to the passage of this act, a "qualified security" was defined as a security issued by a "domestic corporation" that is not readily tradable on an established securities market. This provision changed "domestic corporation" to "domestic C corporation," thus making S corporation securities ineligible. This provision conforms to federal law.
Section 24990.4 is added to the Revenue and Taxation Code.
Treatment of gain from subdivided real estate (IRC §1237)
This provision presumes that a parcel of land held by a taxpayer, other than a C corporation, generally is not treated as ordinary income property solely by reason of the land being subdivided if: (1) such parcel had not previously been held as ordinary income property and if in the year of sale, the taxpayer did not hold other real property; (2) no substantial improvement has been made on the land by the taxpayer, a related party, a lessee, or a government; and (3) the land has been held by the taxpayer for five years. Therefore, land held by an S corporation is generally considered a capital asset. Prior to this act, the presumption that the parcel held was a capital asset did not apply to any corporation.
This act will not require any reports by the department to the Legislature.