Current Developments (Part 1).

• Author: Burton, Hughlene

EXECUTIVE SUMMARY

* The IRS has been more liberal than the Tax Court in granting inadvertent termination relief.

* In 1997, for the first time, more S than C returns were filed.

* There is an increased focus on estate planning with S corporation trusts.

This two-part article 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.

The time period covered in this update--July 16, 1999 to June 30, 2000--continued to focus on implementing the changes made by the Small Business Job Protection Act of 1996 (SBJPA). Three sets of final regulations were issued, dealing with qualified subchapter S subsidiaries (QSubs), and passthrough and adjusted basis issues. Because of the many newly created or converted S corporations, many letter rulings reflected the 1996 legislative changes. With the economy booming, there was also an increased focus on estate planning with S corporation trusts.

As will be discussed in Part II of this article, in the November 2000 issue, S operational issues continued to be addressed by the courts and Treasury, including nine cases on cancellation of debt (COD) income and its effect on an S shareholder's basis for loss. Three cases held that the statute supports a basis increase, three held it does not and three held that suspended losses may be useable in the future. This conflict should provide substantial authority when taking reporting positions and may warrant filing amended returns for open tax years. However, recent final regulations(1) specifically state that COD income is not tax-exempt income; thus, it does not increase stock basis for loss purposes. The Supreme Court will hear oral argument in one Case(2); thus, there may soon be closure on this important issue. Other loss issues are also discussed, is well as the effect of several cash-method accounting cases; their importance is heightened by the 1999 law change forbidding installment sale treatment for accrual-basis taxpayers. Also addressed is Rev. Proc. 2000-22,(3) which permits certain entities to automatically use the cash method of accounting, if they meet a financial statement conformity requirement.

Several recent studies(4) have examined the relative and absolute numbers of S corporations being formed vis-a-vis partnerships, limited liability companies (LLCs) and C corporations. Contrary to some commentators' predictions, C and S corporate formations outnumber LLC formations by about two to one. The LLCs have appeared primarily in the real estate and professional service markets; the S corporation clientele has been much broader. For 1997, 1.755 million partnership returns were fried, compared to 2.45 million S returns. That year (and for the first time), more S returns than C returns were filed.

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, subject to IRS approval, retain its S status continuously. The IRS, at the urging of Congress, has been reasonable in granting inadvertent termination relief. For the period covered, no rulings failed to grant Sec. 1362(f) relief.

Prior to the SBJPA, the IRS had no authority to allow late S elections. Sec. 1362(b)(5) currently gives the IRS the power to correct inadvertent errors in electing S status if the taxpayer shows that the mistake was inadvertent and the entity qualified to be an S corporation and reported as though it were an S corporation.

A plethora of inadvertent election rulings were issued in the period covered, despite several recent procedures(5) designed to ameliorate the need for rulings.

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 UPS).

In several recent letter rulings,(6) the IRS granted S status from date of incorporation, even though it had no record of receiving Form 2553 and there was no proof the taxpayer mailed it.

However, in two similar Tax Court cases, a late S election was disallowed. In Avula,(7) the taxpayer deducted losses from an S corporation. The corporation had never filed Form 2553 and the taxpayers produced no evidence explaining why. At trial, the taxpayer asserted that the form had not been filed "for ethical reasons." The Tax Court denied the election and disallowed the losses.

In Barber,(8) the taxpayer deducted losses from an S corporation. However, the IRS had no Form 2553 on file. The taxpayer maintained he had mailed the form by regular mail. The Tax Court denied the election in the absence of proof of mailing. This case points out the importance of mailing all correspondence to the IRS by registered or certified mail.

These results also indicate that a taxpayer may be better off correcting a mistake before audit. A tax adviser may achieve a superior result by requesting a letter ruling when an error is noted, rather than waiting for an audit.

Late Elections

Rev. Proc. 98-55(9) granted S corporations a 12-month extension to file Form 2553 without obtaining a letter ruling and incurring a user fee. However, in the period covered, the IRS continued to issue numerous letter rulings(l0) allowing late S election filing under Sec. 1362(b)(5), if the taxpayer filed a valid Form 2553 within 60 days of the ruling. In many cases, relief was granted without the taxpayer stating why Form 2553 was untimely filed.(11) A number of rulings(12) involved a lapse in communication between the attorney and accountant as to who was to file Form 2553 for the new company; as a result, no one filed it.

In another case,(13) Form SS-4, Application for Employer Identification Number, and Form 1120S, U.S. Income Tax Return for an S Corporation, had been filed, indicating that the corporation was an S corporation. However, Form 2553 was never filed. In Letter Ruling 200013040,(14) the taxpayer stated he believed Form SS-4 was all that was needed. In both instances, the IRS granted inadvertent election relief.

In other rulings,(15) a general manager, attorney, accountant, tax preparer or financial consultant forgot to mail or complete Form 2553, but the company filed an 1120S and shareholders included the income on their individual returns. The IRS allowed S status at the company's inception in these cases.

In Letter Ruling 200012075,(16) Form 2553 was prepared, but not mailed; in Letter Ruling 200010044,(17) the taxpayer stated he had no knowledge of the Form 2553 requirement. Inadvertent election relief was nevertheless granted.

Who Signs Form 2553?

A question that sometimes arises is who must sign Form 2553. Under Sec. 1362(a) (2), all shareholders who own stock on the date of the election must sign it. If the election is to be retroactive to the beginning of the year, Sec. 1362(b)(2)(B) requires all who owned stock that year (before the election) to sign.

If an election is made under Rev. Proc. 98-55, all affected shareholders must sign Form 2553. Given that the election may be made much later than 2 1/2 months after the beginning of the year, many more signatures may be required. For example, if a corporation wanted to elect S status for calendar year 2000, Form 2553 was due March 15, 2000. However, if it failed to timely file the form, under Rev. Proc. 98-55, it has up to 12 months to file it. Thus, if the form is filed on Oct. 10, 2000, all shareholders from Jan. 1,2000-Oct. 10, 2000 (inclusive) must sign it.

Also, if some shareholders are residents of community property states, their spouse must also sign the election. If the spouse is a nonresident alien, other problems, may arise (discussed below). The same signing requirement is applicable for elections made under letter rulings that grant S status from inception.

Another issue is who must sign Form 2553 for a trust. The trust beneficiary or his legal representative should sign the form, not the trustee. The same is true when filing a qualified subchapter S trust (QSST) election.

In Letter Ruling 200025034,(18) three brothers' families owned stock. A family dispute arose that threatened to destroy the company. Two of the brothers sued under a state...