Current developments.

• Author: Burton, Hughlene A.
• Position: Part 1 - Tax law survey concerning S corportations July 16, 1998-July 1, 1999

This two-part update on S corporation developments reviews and analyzes the recent past's rulings and decisions. Many of the rulings continued to focus on the liberalized S provisions incorporated into the Small Business Job Protection Act of 1996. Part I addresses rulings on S eligibility, elections and terminations.

From a tax perspective, the time period covered in this update--July 16, 1998 to July 1, 1999--continued to focus on implementing the changes made by the Small Business Job Protection Act of 1996 (SBJPA). Because of the many newly created or converted S corporations, many letter rulings reflected the 1996 legislative changes; most significantly, Rev. Proc. 98-55(1) extended the automatic election relief of Rev. Proc. 97-40(2) from six months to a year, waived the letter ruling fee for certain late S elections and permitted the correction of some errors in electing qualified subchapter S subsidiary (QSub), qualified subchapter S trust (QSST) and electing small business trust (ESBT) status.

As will be discussed in Part II of this article, in the November 1999 issue, S operational issues continued to be addressed by the courts and Treasury, including five cases on cancellation of debt income and its effect on an S shareholder's basis for loss; a final regulation on employee stock ownership plans (ESOPs) that own S stock; a consolidated return proposed regulation on the need for two returns (rather than three) when an S corporation is acquired by a consolidated group; and proposed regulations under Secs. 1366-1368. In addition, Notice 99-6(3) advised taxpayers how to handle a disregarded entity's (i.e., a QSub's) payroll taxes. Recent letter rulings highlighted Secs. 1033 and 1031 liability isolation techniques using disregarded entities. Two Tax Court cases(4) created significant opportunities to avoid the repeal of the General Utilities doctrine and to reduce the tax cost of closely held stock transfers.

Statistics reveal the C, S and partnership audit rates.(5) Of the total S returns filed in 1995 and 1996, .92% and 1.04% were audited, respectively. This contrasts with C returns, for which the audit rate was between 2.76% and 14.08% for 1995 and between 3.52% and 16.02% for 1996, depending on asset size. The partnership audit rate was up slightly, to 0.49% and 0.59% respectively, lower than the S audit rate.

The IRS also announced(6) a significant break for small businesses. Fees for letter rulings increased for large companies to $5,000 from $3,650; the fee was reduced to $500 for small businesses with gross incomes of less than $1 million, effective Jan. 11, 1999. This reduction will affect many S corporations and should encourage small businesses to seek assistance when faced with complex tax issues.

Eligibility, Elections and Terminations

The general definition of an S corporation in Sec. 1361 includes restrictions on the type and number of shareholders, as well as the type of corporations, that qualify for S status. If an S corporation violates any of these restrictions, its S election automatically terminates. However, the taxpayer can request an inadvertent termination ruling under Sec. 1362(f) and retain its S status continuously. The IRS, at the urging of Congress, has been reasonable in granting inadvertent termination relief.

Prior to the SBJPA, the IRS had no authority to allow late S elections. Sec. 1362(b)(5) now gives the IRS the power to correct inadvertent errors in electing S status if the taxpayer shows that it made the mistake inadvertently, qualified to be an S corporation and reported as if it were an S corporation. A plethora of inadvertent election rulings were issued in the period covered, despite recent procedures issued to ameliorate the problem.

While some commentators had predicted that S status would not be the future entity of choice because of the expected popularity of limited liability companies (LLCs), hundreds of ruling requests have involved new businesses making procedural errors in electing S status.

Elections

Filing an S Election

To qualify as an S corporation, the corporation and all the shareholders on the date of the election (as well as other affected shareholders) must timely file a valid Form 2553, Election by a Small Business Corporation (under section 1362 of the Internal Revenue Code). `This election should be sent by certified mail (return receipt requested), registered mail or a pre-approved private delivery service (e.g., Federal Express, Airborne Express, DHL or United Parcel Service).

In Letter Ruling 9904011,(7) the IRS granted S status from date of incorporation, even though it did not receive Form 2553 and there was no proof of mailing. However, in Fankhauser,(8) under similar facts, the election was disallowed. The taxpayer maintained that the election was mailed with the corporation's Form SS-4, Application for Employer Identification Number; the Service had no record of receiving the S election. The Tax Court denied the election, because the form had not been mailed either registered or certified mail, the taxpayer had no mailing record and the Sixth Circuit (to which an appeal would lie) strictly adhered to the Sec. 7502(c) requirements. The letter ruling route often generates a more favorable result than the courts on such facts.

Late Elections

Continuing the trend, Rev. Proc. 98-55 extended Rev. Proc. 97-40 to allow late S elections without obtaining a letter ruling (and expending the user fee). The time to file a late election was extended from six to 12 months. (Rev. Proc. 97-48(9) had specified only two situations granting automatic relief for a late S election.)

The procedure applies only to a corporation (1) that did not timely file an S election under Sec. 1362(a)(1), (2) for which an S election was filed within 12 months of the election's original due date and (3) for which the unextended due date of the return (excluding extensions) for the first year the corporation intended to be an S corporation has not passed.

To be granted relief under the procedure, a taxpayer must file a valid Form 2553 with the required signatures and the statement "FILED PURSUANT TO REV. PROC. 98-55" at the top of the form. A statement must be attached explaining the reason for the failure to timely file the S election. Rev. Proc. 98-55 also grants an extension of time to file late ESBT, QSST and QSub elections (discussed below).

Who Signs Form 2553?

A question sometimes arises as to who must sign Form 2553. Under Sec. 1362(a)(2), all shareholders who own stock on the date the election is made must sign it. If the election is to be retroactive to the beginning of the year, Sec. 1362(b)(2) (B) requires the signatures of all shareholders who owned stock that year (prior to the election). In Letter Ruling 9909010,(10) all shareholders existing at the date of the resolution to elect S status consented to the election. Between that date and when Form 2553 filed, new shareholders acquired stock, but did not sign Form 2553; the corporation believed that only shareholders at the time of the election decision had to consent. The IRS ruled that the omission of the new shareholders' signatures invalidated the election, but that the omission was inadvertent; thus, the corporation would be treated as an S corporation from the effective date of the Form 2553.

If an election is made under Rev. Proc. 98-55, the corporation should ensure that all affected shareholders sign Form 2553. Given that the election may be made much later than two and one-half months after the beginning of the year, many more signatures may be required. If some shareholders are residents of community property states, their spouses should also sign the election.

Another issue is who must sign Form 2553 for a trust. In Letter Ruling 9917058,(11) an individual signed both Form 2553 and the QSST election as the trustee. The IRS ruled that the individual should have signed the elections on behalf of the beneficiary as legal representative. The election with the signature as trustee was invalid; however, as the...