S corporation current developments: S corporation eligibility and elections, operations, reorganizations and proposed legislation.

• Author: Karlinsky, Stewart S.

From a tax perspective, the period covered in this update--August 1993 through July 1994--has held some pleasant surprises for S corporations and their shareholders. There has been an increased number of letter rulings on proposed S corporate divisions (Sec. 355), the normal plethora of inadvertent termination rulings regarding a qualified subchapter S trust (QSST} beneficiary's failure to make a timely election, and an increase in the number of rulings on the active or passive nature of rental income, following the recently released, more liberal final regulations under Sec. 1362.(1) Although letter rulings are not precedential for anyone but the requesting taxpayer, they signal the direction in which the Service is moving, and are substantial authority for taking tax return positions; the granting of inadvertent termination requests is also of interest to the S corporation tax adviser.

This update will also cover final regulations, including a Sec. 338 regulation that signifiantly' increases the value of the S corporation as a target in an acquisition, court decisions, and a revenue ruling that revokes a 17-year-old lRS postition on the use of multiple S corporations to circumvent the 35-shareholder limit. S corporation current developments will be presented in four major categories: eligibility and elections; operations; reorganizations; and proposed legislation.

Eligibility and Elections

The Code imposes many restrictions on electing and structuring an S corporation. Given that Sec. 1362(f) requires taxpayers to request a ruling if an inadvertent termination occurs, it is no surprise that the IRS issues numerous rulings annually covering eligibility and elections. This update separates the rulings into three categories: shareholder eligibility, corporate eligibility and elections.

* Shareholder eligibility

Trusts: To keep the S corporation rules simple, there are significant limitations on who can be an eligible shareholder. The area of greatest confusion concerns which type of trust qualifies as a shareholder. From past rulings, it is clear that voting trusts and revocable living trusts qualify, while individual retirement accounts (IRAs) do not. If S corporation stock is transferred to a non-qualifiying shareholder, the S election terminates. However, the corporation may request a ruling under Sec. 1362(f). If the Service rules the termination to be inadvertent, the corporation retains its S status continuously.

Two current letter rulings so held. In letter Ruling 9426036,(2) an S corporation issued stock to grantor trust. In addition, stock was issued to an IRA with assurance from counsel that it was a permitted shareholder. Subsequently, it was determined that the credit trust was not a grantor trust and thus, not a permitted shareholder. Counsel also notifed the corporation that an IRA was not a qualified shareholder. As soon as the corporation was aware of these problems, it merged with a limited partnership that took over its business while the corporation ceased to exist. The Service ruled that the transfer of stock to the credit trust was an inadvertent termination and that the corporation's S status remained intact until the merger without interruption. The credit trust and IRA were to report S corporation income and deductions for the period those entities held the S shares.

Similarly, in Letter Ruling 9416014,(3) the service ruled that the sale of S corporation stock to an IRA was an inadvertent termination. There, the corporation sold stock to an IRA without knowing that it was not a qualified shareholder. As soon as the mistake was discovered, the stock was conveyed back to the corporation and reissued to the individual. It is unclear in this ruling which entity had to pay the tax on the S corporation's income earned while the stock was held by the IRA. presumably, the Service requires the trust to report the income and pay the tax.

QSSTs: A QSST must follow certain rules. The trust beneficiary must elect to be an S shareholder, and if such election is not made, S status technically terminates. If this occurs, the S corporation can request a Sec. 1362(f) inadvertent termination ruling.

In Letter Ruling 9426035,(4) S stock was held by a living trust that qualified as an S shareholder. When one trust beneficiary died, the stock automatically transferred to a marital trust that also qualified as an S shareholder. However, the trustee of the marital trust failed to make a timely QSST election, technically terminating S status. When this error was discovered, the deceased beneficiary's surviving spouse made the election. The Service ruled that the termination was inadvertent and allowed the corporation to retain S status without interruption.(5)

The failure to make a QSST election has been the subject of countless rulings for many years. With the issuance of Rev. Proc. 94-23,(6) however, the Service reduced the number of such rulings that will be required in the future. Rev. Proc. 9423 provides automatic inadvertent termination relief to corporations whose S corporation status has been terminated because the trust beneficiary failed to file a timely QSST election. Automatic relief applies if S stock is transferred to a trust after the S corporation has already qualified, and the trust filed its tax returns as if it were an S shareholder. Note: The procedure does not apply when the QSST beneficiary fails to file an election contemporaneously with the S election. The Code also places restrictions on the type of distributions a QSST can make. Trusts may violate these requirements if they fail to make timely distributions or make distributions to someone other than the income beneficiary. The service issued several rulings regarding these issues.

In Letter Ruling 9349009,(7) three trusts wanted to make substantial distributions of voting trust certificates and nonvoting common stock for estate planning purposes. However, the beneficiaries wanted the distributions to be made from trust principal, not income. The Service ruled that the distributions of trust principal would not disqualify the trusts as S corporation shareholders.

Letter Ruling 9424014(8) addressed two issues concerning a QSST. An individual (A) set up a living trust (Trust X) that qualified as an S shareholder. On A's death, the stock in Trust X automatically transferred to a marital trust (Trust Y). However, the Trust Y trustee and the beneficiary failed to make a QSST election. In addition, another trust (Trust B) owned by A held S stock. At A's death, the assets in the Trust B were to be distributed to his three children. Under Sec. 1361(c)(2), Trust B was deemed to have terminated at A's death and the assets and to be transferred within two years of the date of death. If Trust B failed to timely distribute the assets, it became an ineligible shareholder that terminated the corporation's S status. The distribution from Trust B was delayed beyond the two-year period. Both problems (failure of Trust Y to make a QSST election and failure of Trust B to distribute assets) were corrected as soon as they were discovered. The Service ruled that the termination was inadvertent and allowed the corporation to retain S status.

The holding in Rev. Rul. 93-79(9) was less favorable. There, a trust was an S shareholder. However, the trust's terms did not satisfy the corpus distribution requirements in Sec. 1361(d)(3)(A)(ii). A court order retroactively reformed the turst to meet that section's requirements. The Service, rejecting Flitcroft,(10) ruled that the court order did not have a retroactive effect in determining the trust's eligibility to be an S shareholder. Because the trust did not qualify as an S shareholder until after the court order, the corporation did not qualify as an S corporation prior to the change. Thus, the...