June 13, 2018

Shareholder Cannot Make S Corp. Separately Stated Item Election

Houston Tax Attorney Blog

Houston Tax Attorney

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S corporation’s account for separately stated items that flow through to the shareholder’s tax returns. They are computed on page 3 of the Form 1120S and then listed separately on the Schedule K-1. The idea for breaking these items out separately is that they can impact the shareholder’s individual returns differently. That makes sense, but it also causes problems. This is evidenced by the Caselli v. Commissioner case, which involves the common fact pattern of a restaurant owner going back to claim missed FICA tip credits.

The Facts & Procedural History

The taxpayer was a co-owner of a business entity that held several restaurants. The business entity was taxed as an S corporation. For Federal income tax purposes, the business entity deducted the FICA payments it made for the tips paid to employees. The business did not make an election to take a tax credit for these payments.

The taxpayer reported the flow thru items of income and expense from the business on his personal tax returns. Subsequently, the taxpayer filed amended tax returns to claim FICA tip credits.

The IRS disallowed the claims given that the business had already deducted the FICA payments. Litigation ensued.

FICA Tip Credits for Restaurants and Others

FICA, which is the abbreviation for Federal Insurance Contributions Act, is a tax that funds Social Security and Medicare. It is levied on employee wages.

Businesses whose employees receive tips can deduct the FICA payments or take a tax credit for the payments. The credit allows a dollar-for-dollar reduction of Federal income taxes. This reduction is typically more than the reduction in tax stemming from deductions for FICA taxes. Thus, the FICA tip credit can help save restaurant and other business owners taxes.

These credits are often overlooked. They fall into the missed opportunity category.

This brings us to the Caselli case. The question in the case is whether the shareholder who is entitled to the FICA tip credit can amend their tax return to take missed credits.

The Entity-Only Election Rules

The court in Caselli notes the general rule that tax elections for separately stated items for an S corporation have to be made at the S corporation level. Shareholders cannot make the elections.

According to the court, this precludes the taxpayer-shareholder from taking the FICA tip credits. The rationale is that the election could impact the positions of the other shareholders. This is why our tax laws carve out separately stated items for S corporations in computing flow thru entity income and expense.

But the court was not presented with the fact pattern and did not address whether the S corporation could simply make the election by filing amended returns (perhaps it could have done this even during the course of the litigation). If the S corporation had done this, as long as the taxpayer-shareholder’s refund claims were timely filed, presumably the shareholder would get the benefit (it may be that the taxpayer’s remedy is 9100 relief).

Tax return preparers will appreciate the problems presented by these rules. This entity-only election rule is often problematic, as evidenced by this case. It often comes up when a business is transitioning, terminated, etc. and the business’s tax preparer was not aware of the tax benefit, such as the FICA tip credit, or aware that the benefit applied. How do you fix this issue, even if caught in time, when the business decision makers who would know of the issue are no longer around or the business is no longer operating such that it can change an election it had made?

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