Current developments in S corporations.

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

EXECUTIVE SUMMARY

* Final regulations give guidance for changes made to S corporations by the AJCA and the 60 Zone Act.

* The IRS provided simplified relief procedures in Rev. Proc. 2007-62 for certain taxpayers for late-filed S corporation elections and late-filed entity classification elections that are intended to be effective on the same day.

* The IRS granted numerous requests for relief to taxpayers who had failed to timely file an S corporation election or had terminated their S corporation elections through violations of the various S corporation eligibility rules or failures to timely file a QSST or ESBT election.

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Part I of this two-part article, in the October issue, examined recent S corporation operational tax issues. Part II of the article discusses S corporation eligibility, elections, and termination issues, including guidance for changes made by the American Jobs Creation Act of 2004 (48) (AJCA) and the Gulf Opportunity Zone Act of 2005 (49) (the GO Zone Act), significant issues related to second class of stock, and a notice that provides a simplified method to make an S election. In addition, numerous letter rulings on corporate and shareholder eligibility are discussed.

Recent Law Changes

There have been numerous tax law changes in the past few years, each of which has included provisions that affected S corporations. This year Treasury issued final regulations that provide guidance on changes made by the AJCA and the GO Zone Act to the rules governing S corporations. (50) Specifically, the regulations address three S corporation issues:

1. The S corporation family shareholder rules;

2. The definition of "powers of appointment" and "potential current beneficiaries" regarding an electing small business trust (ESBT); and

3. The allowance of suspended losses to the former spouse of an S corporation shareholder.

A major change in the AJCA was to treat family members as one shareholder. The regulations retain the provisions of Notice 2005-91 (51) that describe certain entities other than individuals that will be treated as members of the family. In addition, the regulations clarify that the "six-generation" test is applied on the latest of (1) the date the S election is made; (2) the earliest date an individual who is a member of the family holds S stock; or (3) October 22, 2004.

A question that arises related to an ESBT is what provisions qualify as a power of appointment. The regulations state that the ability to add beneficiaries to an ESBT is generally a power of appointment but will be disregarded to the extent it is not exercised. Another important issue for ESBTs is who is considered a potential current beneficiary. The regulations amend the definition of "potential current beneficiary" to provide that all members of a class of unnamed charities that may receive distributions are to be treated as one potential current beneficiary. However, each named charity is treated as a separate potential current beneficiary and thus a separate shareholder.

Finally, the AJCA allowed ex-spouses to use suspended losses if the ex-spouse received the S stock under a divorce decree. The regulations explain how the suspended losses should be allocated between the two spouses. The transferor spouse will be allowed to use all of a suspended loss from previous years in the year the stock is transferred. Any loss that is not used in the year the stock is transferred must then be prorated between the shares owned by the transferor spouse and the transferee spouse based on their ownership at the beginning of the succeeding tax year.

Example: A owns all 100 shares of an S corporation. As of December 31, 2006, A has a zero basis in his S corporation shares. For 2006, the S corporation has $100 in losses, which A cannot use because of the basis limitation under Sec. 1366(d)(1). On July 1, 2007, A transfers 50 shares to B, A's former spouse, pursuant to a divorce that qualifies under Sec. 1041(a). The S corporation has an $80 loss in 2007.

For 2007, the year of the transfer, A may deduct the entire $100 suspended loss from 2006 and his share of the 2007 loss [$60 = (80 x .50 for the first half of the year) + (80 x .25 for the second half of the year)] if he has sufficient basis in the S corporation stock. B can deduct her share of the 2007 loss ($20 = 80 x .25) assuming she has sufficient basis in the stock.

However, if A cannot use any of the 2006 disallowed loss in 2007, that loss is prorated between A and B based on their stock ownership at the beginning of 2008. In this case, A will be deemed to have a $50 suspended loss from 2006 and a $60 suspended loss from 2007 at the beginning of 2008, while B will have a $50 suspended loss from 2006 and a $20 suspended loss from 2007.

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 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. Congress had requested that the IRS be lenient in granting inadvertent election and termination relief, and it is clear from the rulings presented below that the IRS has abided by congressional intent.

Late Elections

In an attempt to reduce the number of late filing requests, the IRS issued Rev. Proc. 2003-43, (52) which grants S corporations, 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. This year the IRS issued Rev. Proc. 2007-62, (53) which supplements Rev. Proc. 2003-43 and 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. A statement explaining the reason for the failure to file a timely election must be included on the Form 2553. A corporation can request relief under Rev. Proc. 2007-62 if:

* The company fails to qualify for S corporation status solely because of the failure to file a timely Form 2553;

* The company has reasonable cause for its failure to timely file Form 2553;

* The company has not filed a tax return for the first tax year the election was intended;

* The application for relief is filed no later than six months after the due date of the tax return, excluding extensions, of the corporation for the first tax year the corporation intended to be an S corporation; and

* No taxpayer whose tax liability or tax return would be affected by the S corporation election has reported inconsistently with the S corporation election.

It appears that Rev. Proc. 2003-43 is having its intended effect. Even though the IRS continues to receive late-filing requests, (54) the number of letter rulings issued this year is considerably less than the number issued in years before the procedure's issuance. In most instances this year, 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. (55)

In one instance, (56) the corporate minutes reflected the company's desire to be an S corporation, and the corporation contended that Form 2553 had been filed, but the IRS did not have a record of its being filed. Generally, in these situations, the corporation and the shareholder have treated the entity as an S corporation, and the only step they have forgotten is to file the Form 2553.

In several other situations, (57) 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 had some issues to resolve to make sure the S election was valid. Likewise, in Letter Rulings 200802005 and 200802017 (58) the Service ruled that there was reasonable cause for the late election, but the ruling was contingent on the entity qualifying for S status.

The Service has been relatively lenient in the past few years about granting relief for a late S election. However, in Letter Ruling 200827019 (59) the Service ruled against the taxpayer. In this situation, the corporation failed to file an S election. The corporation was also sporadic in filing its tax returns. A Form 1120, U.S. Corporation Income Tax Return (C corporation tax return), was filed for its first two years, no tax return was filed in year 3, and a late Form 1120S for year 3 was filed in year 4. The Service concluded that the corporation failed to establish reasonable cause for not filing a timely S election and disallowed the election. This ruling should remind taxpayers and tax advisers that relief from failing to file Form 2553 is not automatic, and the company must be able to provide a valid reason for the failure.

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...