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Tuesday, July 16, 2002
Planning to avoid the Massachusetts "Sting Tax" on Large S Corporations By Jeffrey Hart, Esq.

By Jeffrey Hart, Esq.

Massachusetts imposes a corporate tax at a rate of 3% - 4.5% on taxable income of S corporations such as XYZ with more than $6 million of gross receipts. Under Massachusetts regulations, a Massachusetts Business Trust (or corporate trust) that is an S corporation for federal income tax purposes does not qualify for treatment as an S corporation in Massachusetts and is, therefore, not subject to the special Massachusetts tax on large corporations. Instead, an MBT is subject to tax at the entity level as an individual under the provisions of M.G.L. c 62, §8.

Under prior law, the Massachusetts personal income tax relied on the definitions found in the 1986 Internal Revenue Code. However, for the limited purpose of defining S corporations and characterizing income as S corporation income, the Massachusetts corporation regulations adopt the current Code. Massachusetts recently incorporated into the Massachusetts personal income tax law the Code as amended and in effect on January 1, 1998. As a result of this Code update, Massachusetts has adopted many of the Federal tax law changes that have been enacted by Congress in the past ten years.

Under recent federal tax law changes, S corporations are allowed to own qualified subchapter S subsidiaries ("Q-Subs"). The Q-Sub must be wholly owned by the S corporation parent and the parent must elect Q-Sub treatment for its subsidiary. For Federal tax purposes, the Q-Sub is not treated as a separate corporation. All of the Q-Sub's assets, liabilities and items of income, deductions and credits are treated as those of the S corporation parent. These items then flow through to the shareholders. A subsidiary corporation that meets the expanded definition of an S corporation for Federal tax purposes will be eligible for S corporation treatment in Massachusetts if it is otherwise eligible for such treatment under the S corporation regulations.

In Massachusetts Technical Information Release (TIR 97-6), Massachusetts attempted to explain how the Federal tax law changes affect eligibility for S corporation treatment under the Massachusetts personal income and corporate excise tax statutes. Because Massachusetts law makes no specific provision for a Q-Sub, the DOR will look to the Internal Revenue Code to determine how the Q-Sub is to be taxed. There is no provision in the Massachusetts corporate excise statute that allows the Commissioner to disregard the existence of a Q-Sub that falls within the definition of a foreign or domestic corporation under M.G.L. c. 63, §30. The TIR indicated that a Federal S corporation with a Q-Sub will be subject to the principals of the corporate excise statute in the S corporation regulations.

It appeared, although not clear from the 1997 TIR, that a Federal S corporation which is a Massachusetts Business Trust with a wholly-owned Q-Sub would be subject to Massachusetts taxation as follows:

The Q-Sub (subsidiary) would not itself subject to the net income measure of the corporate excise since all of its income is treated as that of the parent under the Code. The Q-Sub must file a corporate excise tax return to report any corporate excise tax attributed to its tangible property or taxable net worth and the minimum corporate excise.

The Massachusetts Business Trust (parent) would report all of the income of the Q-Sub and pay the tax at individual rates. The MBT will be taxed at 5.95% for operating income, 5% for capital gains, and 12% for dividends, but it would not be subject to the net income measure of the S corporation tax. The special 3% - 4.5% tax on large S corporations would not apply.

In Massachusetts Technical Information Release (TIR 99-17), issued on November 30, 1999, Massachusetts confirmed the above analysis and ruled that the Q-Sub would not be subject to the net income measure of the corporate excise since all of its income is treated as that of the parent under the Code. The MBT will report all of the income of the Q-Sub and pay the tax at individual rates. The MBT will not be subject to the net income measure of the S corporation tax.

RESTRUCTURING

To effectuate a restructuring of XYZ, the corporation=s shareholders would organize a new entity, e.g., XYZ Associates Trust ("XYZ Trust"), as a Massachusetts Business Trust. XYZ Trust would elect treatment as an S corporation for Federal income tax purposes. After creating XYZ Trust, the shareholders of XYZ would then transfer their S corporation stock into XYZ Trust in exchange for shares of stock representing the beneficial interest of XYZ Trust. XYZ Associates Trust would then make an election to treat XYZ as its own Q-Sub. Assuming a valid business purpose, the federal tax law will recognize this transaction as a tax-free reorganization. For corporate law purposes, the business continues to be operated out of XYZ, just as before. XYZ Trust would file its own S election, file a Q-Sub election, and file a "check the box" election to ensure classification as a corporate entity.

Among the potential negative aspects of the plan are the unavailability of Massachusetts tax losses to the shareholders of the corporation (NOL's do not carry forward in a Business Trust), and the possibility that out of state shareholders will be adversely affected by the entity level tax in Massachusetts. The traditional aspects of corporate law governing the relationship of officers, directors, and shareholders would now be governed by the law applicable to Massachusetts corporate trusts.




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