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any strategy he adopts, the gifts of surplus cash he makes to his children may subject him to a federal
gift tax. This gift tax supplements the federal estate tax, which imposes a tax on the transfer of assets
from one generation to the next. Lifetime gifts to the next generation would, in the absence of a gift
tax, frustrate estate tax policy. Fortunately, in order to accommodate the tendency of individuals to
make gifts for reasons unrelated to estate planning, the gift tax exempts gifts by donors of up to
$13,000 per year to each of their donees. That amount is adjusted for inflation as years go by.
Furthermore, it is doubled if the donor‟s spouse consents to the use of his or her $13,000 allotment to
cover the excess. Thus, Morris could distribute up to $26,000 in excess cash each year to each of his
two children if his wife consented.
In addition, the federal gift tax does not take hold until the combined total of taxable lifetime gifts
in excess of the annual exclusion exceeds $1 million (in 2009). Thus, Morris can exceed the annual
$26,000 amount by quite a bit before the government will get its share.
These rules may suggest an alternative strategy to Morris under which he may transfer some portion
of his stock to each of his children, and then have the corporation distribute dividends to him and to
them directly each year. The gift tax would be implicated to the extent of the value of the stock in the
year it is given, but from then on no gifts would be necessary. Such strategy, in fact, describes a fourth
circumstance in which the subchapter S election is recommended: when the company wishes to
distribute profits to nonemployee stockholders for whom salary or bonus in any amount would be
considered excessive. In such a case, like that of Victor, the owner of the company can choose
subchapter S status for it, make a gift to the nonemployee of stock, and adopt a policy of distributing
annual dividends from profits, thus avoiding any challenge to a corporate deduction based on
unreasonable compensation.
Making the Subchapter S Election
Before Morris rushes off to make his election, however, he should be aware of a few additional
complications. Congress has historically been aware of the potential for corporations to avoid
corporate-level taxation on profits and capital gains earned prior to the subchapter S election, but not
realized until afterward. Thus, for example, if Morris‟s corporation has been accounting for its
inventory on a last in, first out (LIFO) basis, in an inflationary era (such as virtually any time during
the past 50 years) taxable profits have been depressed by the use of higher-cost inventory as the basis
for calculation. Earlier lower-cost inventory has been left on the shelf (from an accounting point of
view), waiting for later sales. However, if those later sales will now come during a time when the
corporation is avoiding tax under subchapter S, those higher taxable profits will never be taxed at the
corporate level. Thus, for the year just preceding the election, the tax code requires recalculation of the
corporation‟s profits on a first in, first out (FIFO) inventory basis to capture the amount that was
postponed. If Morris has been using the LIFO method, his subchapter S election will carry some cost.
Similarly, if Morris‟s corporation has been reporting to the IRS on a cash accounting basis, it has
been recognizing income only when collected, regardless of when a sale was actually made. The
subchapter S election, therefore, affords the possibility that many sales made near the end of the final
year of corporate taxation will never be taxed at the corporate level, because these receivables will not
be collected until after the election is in effect. As a result, the IRS requires all accounts receivable of