Current developments.

• Author: Burton, Hughlene A.
• Position: Part 1 - Recent legislation, cases, rulings, regulations and other developments in the S corporation area

EXECUTIVE SUMMARY

* Notice 2005-91 offers guidance on how to make the "family election."

* The transactions addressed in IRS letter rulings are becoming more complex.

* Many rulings were issued on shareholder eligibility.

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Part I of this two-part article discusses developments in S eligibility, election and termination issues during the past year (July 2005-June 2006), including changes related to the American Jobs Creation of Act of 2004 (AJCA), a notice that explains the family shareholder election procedure, and a case on permitted year-ends for S corporations. In addition, letter rulings on corporate and shareholder eligibility are addressed. Part II, in the November 2006, issue will cover S corporation operational issues.

Eligibility, Elections and Terminations

The general definition of an S corporation includes restrictions on the type and number of shareholders, as well as the type of corporation that may qualify for the election. If an S corporation violates any of these limits, its S stares automatically terminates. However, the taxpayer can request an inadvertent termination ruling under Sec. 1362(f) and, subject to IRS approval, retain S status continuously. Congress had requested that the Service be lenient in granting inadvertent election and termination relief and it is clear from the rulings presented below that the IRS has listened.

"Family Election"

Prior to the AJCA, an S corporation could have only 75 shareholders. A husband and wife (and their estates) were treated as one shareholder. For tax years beginning after 2004, the AJCA increased the shareholder limit to 100; all fanny members are counted as one shareholder, if a family member so elects under Sec. 1361(c)(1)(D). A family consists of a common ancestor, and his or her lineal descendants and their spouses (including former spouses), according to Sec. 1361(c)(1)(B). The common ancestor can be no more than six generations removed from the youngest generation of family shareholders. Indirect ownership, such as a beneficiary of an electing small business trust (ESBT) or qualified subchapter S trust (QSST), will also be included in the one-family-member count. Every member of the family group who owns stock on the election date must consent to the S election. This liberalized treatment does not include nephews, nieces and cousins, as they are not lineal descendants.

Notice 2005-91 (1) offered guidance on how to make the fanny election. According to the notice, any member of the family can make the election by notifying the S corporation. The notification should identify by name the family member making the election, the "common ancestor" of the family the election applies to and the first tax year for which the election applies. In addition, it should include (1) each potential current beneficiary of an ESBT who is a family member; (2) the income beneficiary of a QSST that makes the QSST election, if that income beneficiary is a family member; (3) each beneficiary of a trust who is a family member, if the trust was created primarily to exercise the voting power of stock transferred to it; (4) the family member for whose benefit a trust described in Sec. 1361(c) (2)(A)(vi) was created; (5) the deemed owner of a trust treated as wholly owned under subpart E of Part I of subchapter J of Chapter 1 of Subtitle A of the Code, if that deemed owner is a family member; and (6) the owner of a disregarded entity, if that owner is a qualified member of the family.

The vast majority of S corporations do not have an excess-shareholder issue, but this year an S corporation requested Sec. 1362(f) inadvertent termination relief due to its number of shareholders. (2) The articles of incorporation limited the number of shareholders. However, shares were issued to too many investors, thus violating the articles of incorporation. As soon as the corporation became aware of the problem, it took corrective action. The entire time it had too many shares outstanding, it filed returns as if it were an S corporation. The Service concluded the corporation's S status had not terminated.

Other Elections

Late elections: In an attempt to reduce the number of late-filing requests, the IRS issued Rev. Proc. 2003-43, (3) which grants S corporations, qualified subchapter S subsidiaries (QSubs), ESBTs and QSSTs a 24-month extension to file Form 2553, Election by a Small Business Corporation, Form 8869, Qualified Subchapter S Subsidiary Election, or a trust election, without obtaining a letter ruling. It appears that the procedure is having its intended effect. Even though the IRS continues to receive a number of late-filing requests, (4) the number of letter rulings issued this year is less than half the number issued in the year prior to the procedure's issuance. In all those rulings, the IRS allowed S status from inception under Sec. 1362(b)(5), as long as the taxpayer filed a valid Form 2553 within 60 days of the ruling.

In a number of these situations, (5) the corporate minutes reflected the company's desire to be an S corporation and it contended that Form 2553 had been filed, but the Internal Revenue Service Center had no record of the filing. In another ruling, (6) the corporation filed both Form SS-4, Application for Employer Identification Number, indicating it planned to be an S corporation, and Form 1120S, U.S. Income Tax Return for an S Corporation. The shareholders included the income on their returns, but the company failed to file Form 2553.

In another instance, (7) a corporation failed to timely file (1) Form 2553, (2) an ESBT election for a trust that was a shareholder and (3) QSub elections for its subsidiaries. The Service granted the corporation relief from termination for all three types of elections.

In some situations, an entity is formed as either a limited liability company or a limited liability partnership, but seeks to be treated as an S corporation. In the past, the entity had to file Form 8832, Entity Classification Election, and Form 2553. In several instances, (8) the entity planned to file Form 8832, electing to be treated as a corporation, and Form 2553 to be taxed as an S corporation. Neither election was actually filed. The Service granted these entities relief and allowed S status from inception, as long as both forms were filed within 60 days of the ruling.

Treasury issued final regulations in 2005 (9) that eliminate the need to file Form 8832. Instead, a partnership or disregarded entity that would otherwise qualify as an S corporation and that makes a timely and valid election to be treated as an S corporation on Form 2553, will be deemed to have elected to be classified as an association taxable as a corporation. This regulation is effective for elections after July 20, 2004. Even though Form 8832 does not need to be filed when the election is made, the corporation must attach a copy to its first tax return. With the issuance of this regulation, the number of late-ruling requests should be reduced significantly.

In another case, (10) a corporation intended to be an S corporation, but failed to timely file Form 2553. The state...