Current developments in S corporations.

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

This article, the second of two parts, provides an annual update of recent IRS rulings, guidance, and other developments concerning S corporations. It discusses S corporation eligibility, elections, and termination issues, including passive investment income. It also covers significant issues related to second class of stock, trusts owning S corporation stock, and numerous letter rulings on corporate and shareholder eligibility. The first part, in the October issue, examined recent S corporation operational issues. This update covers July 1, 2010-June30, 2011.

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Eligibility, Elections, and Terminations

The general definition of an S corporation includes restrictions on the type and number of its shareholders as well as the type of corporation that qualifies 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 relief for inadvertent late or erroneous elections and inadvertent terminations, and it is clear from the rulings presented here and in past years that the IRS has abided by congressional intent.

When to make an S election and when and whether that election should be terminated are important issues that a corporation must observe. In August 2010, Treasury issued temporary and proposed regulations concerning deferral of income recognition from discharge of business indebtedness under Sec. 108(i) (1) that could affect these tax planning decisions. Under these new temporary and proposed regulations, both the election of S status and the termination of a corporation's S status can be considered an event that accelerates otherwise deferred recognition. Thus, practitioners must be aware that either of these decisions could affect shareholders. Under these regulations, it is more important than ever to make sure that potentially affected S corporations maintain their 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 far fewer rulings in the period covered by this update than in the past. In most of those it did issue, the IRS allowed S status under Sec. 1362(b) (5) as long as the taxpayer filed a valid Form 2553 within 120 days of the ruling. In the past, S corporations had been allowed only 60 days. In several other situations, (5) the IRS ruled that a 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 most private letter rulings on timely elections during this period, the taxpayer was granted relief under Sec. 1362(b)(5) if it could establish reasonable cause for the failure to make a timely election and show that granting the relief would not prejudice government interests. However, in Letter Ruling 201123013, (6) the taxpayer did not establish reasonable cause, and the IRS denied relief. In this ruling, the taxpayer originally planned to be a tax-exempt entity but failed to complete the application. The company then decided to be an S corporation but did not file a timely Form 2553. This appears to have been a case of the taxpayer's not knowing which type of entity it wanted to be, so it ended up as neither.

In Letter Ruling 201123021, (7) the shareholders made several wrong steps. First, the corporation planned to be an S corporation but did not file a timely Form 2553. In addition, the shareholders executed a formal shareholder agreement that may have unintentionally created a second class of stock. Also, the corporation's stock was purchased by another corporation that was an ineligible shareholder. The corporation and the shareholders filed their tax returns as if the company were an S corporation. For all three missteps, the IRS ruled that the S election was terminated inadvertently and allowed the company to retain its S status.

Sometimes an entity is formed as a limited liability company (LLC) or a limited liability partnership 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, 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 makes a timely and valid S corporation election on Form 2553 will be deemed to have elected to be classified as an association taxable as a corporation. Even though the regulations do not require a corporation to file Form 8832 when the election is made, the corporation must attach a copy to its first tax return.

Nonetheless, in several instances (8) this year, entities failed to file either of the elections (Form 2553 or Form 8832). In all these instances, the IRS granted relief and allowed the entities S status from inception, as long as they filed both forms within 120 days of the ruling.

Who signs Form 2553: To qualify as an S corporation, the corporation and all its shareholders as of the date of the election (as well as affected former shareholders) must timely file a valid Form 2553.

This election should be sent by certified mail (return receipt requested), registered mail, or an approved private delivery service (e.g., FedEx, DHL, or UPS). This year in several situations, a corporation did not obtain consent from the appropriate shareholders to make the S election.

In one ruling, (9) the company filed Form 2553 correctly but did not include a valid required QSST election. The IRS concluded that the company's S corporation election was invalid under Sec. 1362(a) (2) because a QSST election for a trust shareholder was not included. 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 if the trust filed a new QSST election within 120 days.

In another instance, (10) a corporation elected to be treated as an S corporation but failed to obtain consent from two of its shareholders, making the S corporation election invalid. When the corporation discovered the problem, it sought relief. The IRS concluded that the 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 election's original date, as long as the two shareholders filed a signed consent indicating that it was associated with the original Form 2553.

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 status (those allowed a tax credit for income from Puerto Rico and U.S. possessions). In addition, there are restrictions on who may own the stock of an S corporation and the type of stock an S corporation can issue.

One Class of Stock

Sec. 1361(b)(1)(D) prohibits an S corporation from having more than one class of stock. A corporation has one class of stock if all outstanding shares of its stock confer identical rights to distribution and liquidation proceeds (but not necessarily equal voting rights). Under the facts of Letter Ruling 201043015, (11) an S corporation had class A voting common and class B nonvoting common stock outstanding. The company stated that the two classes of stock differed only as to voting rights and that each share had identical rights to distribution and liquidation proceeds. The company's normal business operations involved borrowing funds from commercial lenders. In connection with a debt restructuring and as consideration for their consent, some lenders received warrants to acquire nonvoting common stock. The warrants were subject to various conditions, put and call rights, and antidilution provisions. The company maintained that the primary purpose for issuing the warrants was to secure consent and restructuring participation by the lenders on terms typical to such transactions. The IRS determined that the warrants came within the exception in Regs. Sec. 1.1361-1(l)(4)(iii)(B)(1) and did not create a second class of stock. A...