Current developments in S corporations.

• Author: Burton, Hughlene A.
• Position: Part 2

Part I of this two-part article, in the October issue, examined recent S corporation operational tax issues. Part II discusses S corporation eligibility, elections, and termination issues, including passive investment income, Sec. 108(i) elections, and a new case that may be helpful to practitioners in the S corporation area. It covers significant issues related to second class of stock, trusts owning S corporation stock, and numerous letter rulings on corporate and shareholder eligibility. This tax update covers the period July 2009-July 2010.

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 restrictions, its S status is terminated automatically. However, the taxpayer can request an inadvertent termination relief ruling under Sec. 1362(f) and, subject to IRS approval, retain its S status continuously. Congress had requested that the IRS be lenient in granting inadvertent election and termination relief, and it is clear from the rulings presented here and in past years that the IRS has abided by congressional intent.

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When to make an S election and when and if that election should be terminated are important issues that a corporation must observe. This year Treasury issued temporary and proposed regulations under Sec. 108(i) (1) that could affect these decisions. Currently, under Sec. 108(i) corporations can elect to defer the recognition of cancellation of indebtedness unless an acceleration event occurs. Under the new temporary and proposed regulations, both the election of S status and the termination of a corporation's S status would be considered an accelerating event. Thus, practitioners must be aware of the fact that either of these decisions could have a major impact on the shareholders due to the acceleration of income. Under these regulations, it will also be more important than ever to make sure that an S corporation maintains its status.

Late Elections

In an attempt to reduce the number of requests for relief from late filings, the IRS issued Rev. Proc. 2003-43, (2) which grants S corporations, qualified subchapter S subsidiaries (QSubs), electing small business trusts (ESBTs), and qualified subchapter S trusts (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. Rev. Proc. 2007-62, (3) which supplements Rev. Proc. 2003-43, provides an additional method for certain taxpayers to request relief for a late S corporation election and a late corporate classification election that is intended to be effective on the same day. To obtain relief under Rev. Proc. 2007-62, the corporation must file a properly completed Form 2553 with its Form 1120S, U.S. Income Tax Return for an S Corporation, for the first year the corporation intended to be an S corporation with a statement explaining the reason for the failure to file a timely election.

It appears that the intent of the revenue procedures is working. Even though the IRS continues to receive late-filing requests, (4) it issued less than a third of the pre-procedure filings. In all the rulings this year, the IRS allowed S status under Sec. 1362(b)(5) as long as the taxpayer filed a valid Form 2553 within 60 days of the ruling.

In several other situations, (5) the IRS ruled that the late filing was inadvertent and granted the corporation relief but did not rule on whether the entity would otherwise qualify for S corporation treatment. Thus, these companies may still have some issues to resolve to make sure the S election was valid.

In two instances this year, (6) taxpayers claimed they had prepared Form 2553 but the IRS had no record of them filing the election. In both cases, the IRS granted the taxpayers relief under Sec. 1362(b)(5).

Practice tip: Tax practitioners should be aware that if past experience is any guide, going to court on this issue will not resolve the issue on a taxpayer-friendly basis.

In some situations an entity is formed as either a limited liability company (LLC) or a limited liability partnership (LLP) but wishes to be treated as an S corporation. In the past the entity had to file both Form 8832, Entity Classification Election, and Form 2553. However, for elections after July 20, 2004, Regs. Sec. 301.7701-3(c)(1)(v)(C) eliminates the need to file Form 8832. Instead, a partnership or disregarded entity that would otherwise qualify to be 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. 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 when filed.

Nonetheless, there were still several instances (7) in which the entity was required to file Form 8832, electing to be treated as a corporation, and then file Form 2553 to be taxed as an S corporation. However, in cases where the entity failed to file either of the elections, the IRS granted those entities relief and allowed S status from inception, as long as both forms were filed within 60 days of the ruling. It should be noted that the number of rulings on this issue should also be drastically reduced in the future.

Who signs Form 2553: To qualify as an S corporation, the corporation and all its shareholders on the date of the election (as well as other affected shareholders) must timely file a valid Form 2553. This election should be sent by certified mail (return receipt requested), registered mail, or a preapproved private delivery service (e.g., FedEx, DHL, or UPS). This year there were several situations in which the corporation did not obtain consent to make the S election from the appropriate shareholders.

In one ruling this year, (8) the company filed Form 2553 to be treated as an S corporation under Sec. 1361. The Form 2553 was correctly completed except that two of its shareholders did not consent to the S corporation election. At the time of the election, the co-executors for an estate failed to consent on behalf of the estate. In addition, the current income beneficiary of a QSST failed to consent to the company's S corporation election. The IRS concluded that the company's S corporation election was invalid under Sec. 1362(a)(2) because the estate and the income beneficiary failed to consent to the company's S corporation election. However, the invalidity of the S corporation election was inadvertent under Sec. 1362(f), and the IRS said it would treat the company as an S corporation and the trust as a QSST.

In another instance, (9) a corporation tried to elect to be treated as an S corporation but failed to obtain consent from one of its shareholders as required. That omission meant that the S corporation election was invalid. When the corporation discovered the ineffectiveness of the election, it sought relief under Sec. 1362(f). The IRS concluded that the ineffective election constituted an "inadvertent ineffective election" within the meaning of Sec. 1362(f) and said the corporation would be treated as an S corporation from the original date of the election.

In Letter Ruling 201017038, (10) a corporation elected to be treated as an S corporation effective on date 1. Prior to that date, shares of the company were transferred to a qualified employee stock ownership plan (ESOP). The corporation had someone sign the Form 2553 for the ESOP; however, that person might not have had proper authority to do so. As a result of the failure of the proper party to sign the consent for the S corporation election, the S election might have been ineffective. In addition, after the corporation made the election, stock in the corporation was transferred to an ineligible shareholder, causing the corporation to no longer be eligible to be an S corporation. The IRS concluded that if the original election was invalid, the ineffective election was inadvertent. Therefore, the corporation would be treated as an S corporation from date 1 until it transferred the stock to the ineligible shareholder.

In another situation, (11) the shareholders of an S corporation engaged in several transactions that were intended to result in A and B owning all the outstanding shares of the S corporation. After the transfers, the only remaining shareholders of the corporation were A, B, and Estate. A stock assignment provided for the transfer of Estate's shares to A for cash. However, the administrator of Estate did not execute the agreement. A and B signed Form 2553 based on their belief that they were the only two shareholders. The administrator of Estate did not sign the Form 2553. On a later date, the Estate administrator executed the assignment of the stock from Estate to A. The IRS concluded that the S election was ineffective because it was not signed by all of the shareholders but that the ineffectiveness was inadvertent. Therefore, the IRS would treat the entity as continuing to be an S corporation.

Finally, an entity elected to be treated as an S corporation. (12) However, due to a clerical error on the entity's share register, the required consent for the election was not sought or obtained from one of its shareholders. As a result, the election was ineffective. The IRS concluded that the entity's election to be treated as an S corporation was ineffective. However, it also concluded that the ineffective election constituted an inadvertent ineffective election under Sec. 1362(f).

Corporate Eligibility

Sec. 1361 does not allow certain types of corporations to elect S status, including certain financial institutions, insurance companies, foreign corporations, and corporations electing Sec. 936...