Eligibility, election and termination issues.

• Author: Karlinsky, Stewart S.
• Position: Current Developments in S Corporations, part 2

Part I of this article, in the October 2004 issue, addressed S operational issues, including tax shelters, loss limits, S employee stock ownership plans (SESOPs) and reorganizations. Part II, below, discusses S eligibility, election and termination issues, including revenue procedures for community property spouses, four-year spread opportunities and when an S election must be made and cases that clarify when an S election is revoked. In addition, regulations on qualified Subchapter S trust (QSST) elections for testamentary trusts were finalized. Lastly, numerous private rulings regarding corporate and shareholder eligibility will be discussed.

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 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 election date (as well as other affected shareholders) must timely file a valid Form 2553, Election by a Small Business Corporation. 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). The burden of proof is on the taxpayer. However, in two recent letter rulings, (43) the Service allowed S status even though the IRS had no record of Form 2553 being filed. Taxpayers have continuously lost on this issue in the courts; these rulings point out that the IRS is more lenient in these matters if the issue is raised before audit than in the courts.

Late elections: Last year, the IRS issued Rev. Proc. 2003-43, (44) which grants S corporations a 24-month extension to file Form 2553 without obtaining a letter ruling and, thus, allows them to avoid user and professional fees. Rev. Proc. 2003-43 also applies to late-filing requests for qualified Subchapter S subsidiaries (QSubs), electing small business trusts (ESBTs) and QSSTs.

It appears that the procedure is having the desired effect. Even though the IRS continues to receive numerous late-filing letter ruling requests, (45) the number decreased substantially this year. In all instances, 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, (46) the corporate minutes reflected that the company wanted to be an S corporation and filed Form 1120S, U.S. Income Tax Return for an S Corporation, indicating the corporation intended to be an S corporation. However, Form 2553 was not filed prior to the ruling request. In other rulings, (47) a lawyer, accountant, tax preparer or financial consultant failed to complete Form 2553, but the company filed Form 1120S and the shareholders included the income on their returns. The government allowed S status at the company's inception in these cases.

In a recent ruling, (48) a corporation was formed prior to the "check-the-box" regulations. The company tried to make an S election, but was denied because of the uncertainty of the company's entity classification. Under the check-the-box regulations, the corporation would be allowed to make an S election. The company requested and was granted relief under Sec. 1362(b)(5), allowing it to be treated as an S corporation from inception.

In another case, (49) the corporate minutes showed that the owners intended the company to be an S corporation; however, no Form 2553 was filed. The company's accountant filed a Form 1120, instead of an 1120S, for the corporation's first year. The IRS ruled that the corporation was eligible under Sec. 1362(b)(5) and could file an S election within 60 days of the ruling. The election would be valid for the company's first tax year. Presumably, amended returns would need to be filed for the corporation and all of its individual shareholders.

Likewise, in another situation, (50) a taxpayer set up a corporation, intending it to be an S corporation; however, the S election was never made. For five years after the corporation was formed, the taxpayer reported his income as a sole proprietorship. The IRS allowed the corporation relief and allowed S status from inception. Like the previous case, it would appear that amended returns would need to be filed for all open years; however, the IRS did not address this problem, nor explain how the closed years should be reported.

Also, in several instances, (51) the entity was a limited liability company (LLC) or a limited partnership that planned to file Form 8832, Entity Classification Election, to be treated as a corporation, then file Form 2553 to be taxed as an S corporation. Neither election was ever filed. 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 a different situation, (52) an S corporation owned a QSub. The parent distributed its stock in the QSub to its shareholders, thus terminating the QSub election. The shareholders intended the subsidiary to be an S corporation after termination of the QSub election; however, no Form 2553 was filed. The Service determined that there was reasonable cause for failing to make a timely S election and allowed the subsidiary S status. The stock distribution would either be a tax-free spinoff or taxable under Sec. 311(d). The IRS did not rule on whether the distribution was taxable.

Who should sign Form 2553: Under Sec. 1362(a)(2), all shareholders who own stock on the election date must sign Form 2553. If the election is to be retroactive to the beginning of the year, Sec. 1362(b)(2)(B) requires all shareholders who owned stock that year, prior to the election, to also sign. In Rev.Proc. 2004-35,53 the IRS provided automatic relief for late shareholder consents for S elections in community property states. Such relief would be allowed to S corporations whose election is invalid because the company failed to include the signature of a community property spouse deemed a shareholder solely because of state community property law, if both spouses reported income consistent with the S election.

To be granted this relief, the corporation must file a signed statement from each of the spouses consenting to the S election and stating that they have reported all income and loss items consistent with such election on all affected returns. A problem could occur in this type of situation if the spouse is a nonresident alien (NRA), because an NRA is an ineligible shareholder. If the spouse is an NRA, he or she may elect dual-resident status to maintain S status.

If one of the S shareholders is a qualified trust, the beneficiary must sign the election for it to be valid, not the trustee. In two letter rulings, (54) the trustee, not the beneficial, signed the S and QSST elections, making them invalid. The Service ruled that the invalid elections were inadvertent and allowed...