This two-part article discusses recent legislation, cases, rulings, regulations, and other developments in the S corporation area. Part I focuses on eligibility, elections, and termination issues.

• Author: Burton, Hughlene A.
• Position: Current Developments in S Corporations, part 2

EXECUTIVE SUMMARY

* The Small Business and Work Opportunity Tax Act of 2007 contains several provisions that affect S corporations.

* Proposed regulations were issued relating to banks that are S corporations.

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Part I of this two-part article discusses S corporation eligibility, elections, and termination issues, including several changes related to the Small Business and Work Opportunity Tax Act of 2007, P.L. 110-28 (SBWOTA), significant trust issues, and a notice relating to permitted year ends for S corporations. In addition, numerous letter rulings on corporate and shareholder eligibility will be discussed.

SBWOTA

The SBWOTA had several provisions that affected S corporations. For the most part these provisions were pro-taxpayer and, unless otherwise noted, will be effective for years beginning after December 31,2006. Some of these will be presented here and others will be discussed in Part II of the article, in the November 2007 issue.

Two provisions of the new law relate to banks that have elected to be S corporations. According to Grant Thornton, LLP, as of March 2005, 2,237 banks had switched to S corporation status. However, only banks (usually community banks) that do not use the reserve method of accounting for bad debts can elect to be S corporations. If the bank changes from the reserve method of accounting for bad debts, a Sec. 481 adjustment must be made; this adjustment generally is included in income over four years. New Sec. 1361(g) allows the bank to elect to take into account 100% of the adjustment the year before it changes to an S corporation, when it is still a C corporation. Therefore, the bank takes the adjustments into account at the entity level (where it enjoyed the benefit of the previous deduction) rather than at the shareholder level.

A second provision helpful to bank S corporations relates to bank director shares. National and state banking laws require a bank's director to own stock. In some cases, a bank will enter into an agreement in which the bank will reacquire the stock when the director ceases to hold the office. Requiring all directors to own stock could create a problem with the shareholder limit, while the repurchase agreement could create a second class of stock. Both of these issues would cause the termination of an S election. New Sec. 1361(f)(1) clarifies that qualifying "restricted bank director shares" are not recognized for any subchapter S provisions. New Sec. 1368(f)(1) also treats any distributions on this restricted stock as income to the director and deductible to the bank.

Note: An interesting question is whether this restricted-bank-director-stock-disregarded status would allow directors to own stock in a qualified subchapter S subsidiary (QSub) and not disqualify the subsidiary bank.

If an S corporation has accumulated earnings and profits (AE&P) at the end of the year and more than 25% of its gross receipts are from passive investment income (PII), the S corporation will be subject to a corporate-level tax. The 2007 act reduces the possibility of an S corporation's being subject to this tax. Under new Sec. 1362(d)(3), capital gains on stocks and securities will not be treated as PII under Secs. 1362(d) and 1375. In a related provision, the new law eliminates S corporation previously taxed income (PTI) attributable to pre-1983 years for corporations that were not S corporations for their first tax year beginning after December 31, 1996. These two provisions apply to tax years beginning after May 25, 2007.

Another new provision makes an S corporation a slightly more attractive vehicle for investments. Sec. 641(c)(2)(C)(iv) allows an electing small business trust (ESBT) to deduct any interest expense it incurs when it borrows funds to purchase S stock. This provision places an ESBT on par will all other taxpayers, including qualified subchapter S trusts (QSSTs), for the deduction. Because ESBT income is taxed at the highest individual rate, this change allows a tax deduction at a 35% tax rate.

A far more anti-taxpayer provision that affects all taxpayers (including S corporations and their shareholders, as well as tax practitioners) is the expansion of Sec. 6694, under which tax practitioners must use a "more likely than not" standard on undisclosed positions for returns prepared after May 25, 2007. (This is in contrast to the "realistic possibility of success" standard that practitioners previously used.) In addition, the amount of the Sec. 6694 penalty has been increased. The revisions to Sec. 6694 constitute major changes to practice standards and penalties that have been in place for many years. Two instances in which this new provision could affect S corporations are (1) basis in debt due to back-to back loans and (2) the calculation of built-in gain under Sec. 1374. (For more on these preparer penalties, see Tax Clinic, p. 582.)

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.

Elections

Late elections: In an attempt to reduce the number of late filing requests, the IRS issued Rev. Proc. 2003-43, (1) which grants S corporations, QSubs, ESBTs, and QSSTs a 24-month extension to file Form 2553, Election by a Small Business Corporation (Under Section 1362 of the Internal Revenue Code), Form 8869, Qualified Subchapter S Subsidiary Election, or a trust election without obtaining a letter ruling. It appears that the procedure is having its intended effect. Even though the IRS continues to receive a number of late-filing requests, (2) the number of letter rulings issued this year is less than half the number issued in years prior to the procedure's issuance. In all 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.

In a number of these situations, (3) 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 shareholder have treated the entity as an S corporation, and the only step they have forgotten is to file the Form 2553. However, in one instance, (4) the IRS allowed S status even though a Form 1120S, U.S. Income Tax Return for an S Corporation, had not been filed. In this ruling, the Service allowed S status from the original date but required the corporation to file a Form 1120S for all years the corporation was deemed to be an S corporation, and the shareholder to file amended Forms 1040 for those years.

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 Forms 8832, Entity Classification Election, and 2553. For elections after July 20, 2004, Treasury issued final regulations that eliminate 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 (5) 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, the entity failed to file either of the elections. The Service granted these entities relief and allowed S status from inception, as long as both forms were filed within 60 days of the ruling.

In one situation, (6) an LLC filed Form 8832 but forgot to file Form 2553. The company and the shareholders filed tax returns as if the company were an S corporation. The IRS determined that the S election was to be treated as timely filed if the company filed Form 2553 within 60 days of the ruling.

In another ruling, (7) a corporation intended to be an S corporation but failed to timely file Form 2553. The state in which the business was incorporated administratively dissolved the corporation for failure to file the proper reports and pay the appropriate taxes. After the dissolution, the business reincorporated. The IRS concluded that the business...