Current developments, part II.

• Author: Karlinsky, Stewart S.
• Position: S corporations

This two-part article on S corporation developments reviews and analyzes recent legislation, rulings and decisions. Part II examines eligibility, elections and terminations.

Part I of this two-part article, in the October 2003 issue, addressed S corporation operational issues, including undercompensation issues, loss limits and corporate reorganizations. Part II, below, discusses S eligibility, elections and terminations. During the time period covered, a revenue procedure (33) extended the deadline to make an S election. Part II also covers numerous letter rulings on corporate and shareholder eligibility.

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 can qualify for an S election. If an S corporation violates any of these limits, its S status is automatically terminated. However, the taxpayer can request an inadvertent termination ruling under Sec. 1362(f) and, subject to IRS approval, retain its S status continuously.

Elections

Filing an S Election

To qualify as an S corporation, the corporation and all its shareholders on the date of the election (as well as other affected shareholders) have to timely file a valid Form 2553, Election by a Small Business Corporation. They should file the election by certified mail (return receipt requested), registered mail or a pre-approved private delivery service (e.g., Federal Express, Airborne Express, DHL or UPS).The burden of proof is on the taxpayer. For example, in Martin Higbee, (34) the shareholders asserted that they had mailed Form 2553, bnt had no proof. The court ruled that their S election was invalid. However, the Service has allowed S status in similar situations in previous letter rulings, which exemplifies that the IRS is more lenient when the issue arises before audit, rather than in the courts.

Late Elections

This year, the IRS issued Rev. Proc. 2003-43, (35) granting S corporations a 24-month extension to file Form 2553 without obtaining a letter ruling, thus avoiding a user fee. To benefit from this procedure, an S corporation has to meet all of the following requirements:

1. The entity has failed to timely file the appropriate election;

2. Fewer than 24 months have passed since the election's original due date;

3. The entity has reasonable cause for failing to make a timely election; and

4. The entity meets one of two sets of additional requirements. The first set requires that:

   * The entity has not filed a return for the first year it intended to make the election;

   * The entity filed an application for relief no later than six months after the return's unextended due date; and

   * All owners have reported their tax liability consistent with an S election.

   The second set of alternative requirements is:

   * The entity has filed a return within six months of the return's original due date; and

   * All the owners have reported income consistent with an S election.

   Based on prior letter ruling requests, the second set of alternatives is the one that most taxpayers meet.

   Rev. Proc. 2003-43 also applies to late-filing requests for qualified subchapter S subsidiaries (QSubs), electing small business trusts (ESBTs) and qualified Subchapter S trusts (QSSTs).

   Even with this procedure and previous lenient ones, the IRS continues to receive numerous late-filing letter ruling requests. (36) In all instances, the IRS allowed S status from inception under Sec. 1362(b)(5), is long as the taxpayer filed a valid Form 2553 within 60 days of the ruling. In a number of these situations, (37) the taxpayer filed Form SS-4, Application for Employer Identification Nmnber, and Form 1120S, U.S. Income Tax Return for an S Corporation, indicating that the corporation was an S corporation. However, the Form 2553 was not filed prior to the riding request.

   In other rulings, (38) a general manager, lawyer, accountant, tax preparer or financial consultant forgot to mail or fill out Form 2553, but the company filed Form 1120S and shareholders included the income on their individual returns. The Service allowed S status at the company's inception in each case.

   In several instances, (39) entities were limited liability companies (LLCs) or limited partnerships that planned to file Form 8832, Entity Classification Election, electing to be treated as a corporation, and then file Form 2553, to be taxed as an S corporation. Despite the fact that the entities never filed either election, the Service granted them refief and allowed S status from inception, as long as both forms were filed within 60 days of the ruling.

   Who Should Sign Form 2553?

   Per Sec. 1362(a)(2), all shareholders who own stock on the election date must sign Form 2553. If the dection is retroactive to the beginning of the year, Sec. 1362(b)(2)(B) requires all who owned stock that year, prior to the election, to also sign. For example, in one ruling, (40) two married couples owned an S corporation. When they filed Form 2553, the wives did not sign the form; however, the taxpayers filed their returns consistent with the company being an S corporation. The Service determined that the S election was inadvertently invalid for failure to attach certain shareholder consents to the election, allowing the corporation to retain its S status.

   In another ruling, (41) an entity intended to be an S corporation, but failed to file Form 2553. An individual bought the stock from the original shareholder believing the company had a valid S election in effect. The Service granted the corporation S status from inception as long as Form 2553 is...