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CCH® PENSION — 05/14/12

Roth IRA was not eligible shareholder of S corporation

A corporation was not eligible for S corporation status because its sole shareholder, a Roth IRA, was not an eligible S corporation shareholder, according to the Court of Appeals in San Francisco (CA-9). Consequently, the corporation was taxable as a C corporation.

An individual incorporated his business and elected subchapter S status. The corporation's sole shareholder in 2003 was a custodial Roth IRA for the benefit of the individual. The IRS issued a notice of deficiency, determining that the corporation was taxable as a C corporation for 2003. The taxpayer filed suit, but the Tax Court sided with the IRS, finding that the Roth IRA did not qualify as an eligible shareholder of the S corporation. The corporation appealed. The central question on appeal turned solely on whether a custodial Roth IRA qualifies as an eligible shareholder for purposes of assessing S corporation taxation.

Application of Rev. Rul. 92-73

Rev. Rul. 92-73 specifies that a trust is a permitted shareholder only where the trust is a grantor trust under Code Sec. 1361(c)(2)(A)(i) or a qualified subchapter S trust that is treated as a trust under Code Sec. 1361(c)(2)(A)(i) pursuant to the election of the beneficiary. The appellate court agreed with the Tax Court that Rev. Rul. 92-73 "provides persuasive guidance that IRAs are ineligible for S corporation shareholders." The distinguishing feature is the deferred income tax treatment, which differentiates IRAs from beneficiaries who are taxed currently on the trust's share of income.

Congressional intent

Moreover, the court found that the legislative history of the S corporation statute favors limited eligibility. In enacting the statute, the appellate court ruled, Congress did not contemplate or intend eligibility for IRAs and other entities entitled to deferred taxation.

Custodial account rules

Finally, the appeals court also rejected the corporation's argument that IRS Reg. §1.1361-1(e)(1) authorizes ownership of S corporation stock by IRAs and Roth IRAs created as custodial accounts. Custodial IRAs and Roth IRAs are different in kind and therefore distinguishable from other custodial accounts, such as those involving minors or disabled individuals, the court held. The latter form of custodial account functions to hold shares for a person who cannot otherwise legally hold them. In such cases, income is taxed currently to that person, in contrast to IRAs and Roth IRAs, where individuals who could legally hold the underlying assets instead choose to place them in such accounts, thereby deferring or exempting taxation of any current income.

Accordingly, the Ninth Circuit affirmed the Tax Court's holding that the Roth IRA was not eligible to own shares of the S corporation. As a result, the corporation was ineligible for S corporation status in 2003 and was, instead, a C corporation for federal income tax purposes.

Source: Taproot Administrative Services, Inc. v. Commissioner of Internal Revenue (CA-9).

For more information, visit http://www.wolterskluwerlb.com/rbcs.

For more information on this and related topics, consult the CCH Pension Plan Guide, CCH Employee Benefits Management, and Spencer's Benefits Reports.

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