Current developments - eligibility, elections and terminations; operations; and legislation.

• Author: Karlinsky, Stewart S.
• Position: Regarding S corporations

From a tax perspective, during the period covered in this update -- September F1996 through August 1997 -- the focus has been on implementing the significant S changes made by the Small Business job Protection Act of 1996 (SBJPA) (enacted on Aug. 20,1996).(1) At the same time, numerous operational issues were also addressed by the courts and Treasury.

Because of the many newly created or C corporate-converted S corporations, there have been a considerable number of letter rulings, announcements, notices and revenue procedures reflecting the 1996 legislative changes. A smaller number of letter rulings involved qualified subchapter S trust (QSST) beneficiaries not making a timely election (due to the SBJPA and Rev. Proc. 94-23(2)) and an even smaller number were released on proposed corporate divisions (Sec. 355) as they apply to S corporations. Some interesting S corporation issues came to the fore: final Sec. 1377 regulations; passive activity loss PAL) utilization; earnings md profits (E&P) determinations; qualified subchapter S subsidiary (QSSS) issues; built-in gain on timber harvesting; the cash method of accounting; Sec. 351 incorporations in which liabilities may exceed adjusted basis; and the joint Committee on Taxation's "Blue Book" comments(3) on recent S corporation legislation. Tax advisers should be aware that many more issues will arise at the state level, as some states have conformed to the Federal S corporation law changes; others have not.

This update is presented in three major categories: eligibility, elections and terminations; operations; and legislative changes, including the provisions of the Taxpayer Relief Act of 1997 (signed into law on Aug. 5, 1997) that affect S corporations, as well as some SBJPA issues that remain unresolved. (Note: Although past updates have included a section on reorganizations, this year's does not, because many fewer letter rulings were issued in the area.)

Eligibility, Elections and Terminations

The general definition of an S corporation in Sec. 1361 includes significant restrictions on the type and number of shareholders, as well as the type of corporations, that can qualify for S status.

If an S corporation violates any of these restrictions, its S election is automatically terminated. However, taxpayers can request an inadvertent termination ruling under Sec. 1362(f) and retain S status continuously. The IRS, at the urging of Congress, has been reasonable in granting inadvertent termination rulings.

Filing an S Election

To qualify as an S corporation, the corporation and all the shareholders on the date of the election (as well as other affected shareholders) should file a valid, timely Form 2553, Election by a Small Business Corporation (under section 1362 of the Internal Revenue Code). It is generally recommended that this election be sent by certified mail/return receipt or by registered mail. Section 1210 of the Taxpayer Bill of Rights 2 allows the use of certain preapproved private delivery services (PDSs) for purposes of Sec. 7502, the "timely mailed as timely filed/paid" rule. Rev. Proc. 97-19(4) provides the criteria to be a designated PDS; according to Notice 97-26,(5) Federal Express, Airborne Express, DHL and United Parcel Service next-day and two-day delivery services qualify as the equivalent of certified mail for such purposes.

Prior to the SBJPA, the Service had no authority to allow late-filed S elections. Sec. 1362(b)(5) now gives the IRS the power to correct inadvertent errors in electing S status if the corporation shows that it made the mistake inadvertently and that it qualified to be an S corporation and acted as though it were an S corporation. Ann. 97-46 offers the taxpayer guidance on how to apply for inadvertent election relief. In most rulings to date, an employee, lawyer, accountant or owner forgot to mail or fin out the Form 2553, but the company filed Form 1120-S, US. Income Tax Return for an S Corporation7 The IRS granted inadvertent relief in each of these rulings.

Continuing the trend, Rev. Proc. 97-408 allows late-filed S elections to be approved without requesting a letter ruling. Now, if a Form 2553 is filed by all the shareholders within six months of the election's due date, and is identified as filed under Rev. Proc. 97-40, no letter ruling (and attendant fee) is necessary. This procedure does not cover QSST and electing small business trust (ESBT) errors.

The fact that this error correction may be retroactive creates the need for amended tax returns at both the corporate and shareholder levels. For example, in Letter Rulings 9720019,9 972201 1 10 and 972202 1,11 the corporation filed as an S corporation, amended the return to file Form 1120, US. Corporation Income Tax Return, and then amended the corporate return again after permission to file S status was granted. Likewise, the shareholders of these corporations were required to amend their individual tax returns many times; because these changes affected multiple years, amended returns were required for aD those years. An interesting but unanswered) question is the proper treatment if some of these years are closed by the statute of limitations.

Corporate Year-End

When a C corporation decides to switch to S status, generally a calendar year-end is required. Notice 97-2012 facilitates this transition. Basically, the notice waives certain limitations of Regs. Sec. 1.442-1 (c) (2) (i) and (v), as well as Sections 4.01 (2) and 5 of Rev. Proc. 92-13.13 This liberalization is in effect for the short period ending Dec. 31, 1996, and assumes that special filing procedures are followed. These include properly completing Forms 2553 and 1128, Application To Adopt, Change, or Retain a Tax Year, and writing "Filed Under Notice 97-20" at the top of both forms.

Corporate Eligibility

One class of stock: Sec. 1361 b) (1) (D) prohibits an S corporation from having more than one class of stock, defined as stock having differing economic rights (distributions and liquidations), rather than different voting rights. In Letter Ruling 9728019,14 an S corporation issued to its shareholders a second class of stock that differed in liquidation rights. From the corporation's inception, the shareholders of both classes of stock were allocated income, loss and separately stated items as though there was only one class of stock. The IRS ruled that this was an inadvertent termination. Reorganizing under Sec. 368(a)(1)(E) results in a more benign tax effect than a redemption under Sec. 302.

In the past, when an S corporation set up employment or consulting agreements or a profit-sharing pool for its employee-owners, there was some concern that this could be interpreted as a second class of stock. Letter Ruling 972002115 allays taxpayers ears. Similarly, Letter Puling 9649039(16) held that an S corporation's notes payable on purchase of property from related shareholders did not give rise to a second class of stock.

Letter Ruling 972801817 dealt with an S corporation whose shareholders were engaged in succession planning. The older generation was going to redeem all of its stock and take back notes from the S corporation. (The family members were not attributed stock from other family members because a Sec. 302(c)(2) election was in effect.) The notes were secured by the corporation's accounts receivable, inventory and equipment, and the collateral was subordinated to the bank's security interest. The Service held that the notes were not a second class of stock. (It is preferable not to secure a debt with the S stock, because, if a default occurs, the conditions of a Sec. 302(c) election may be violated.) This ruling is also instructive because it elaborated on what involvement senior redeeming shareholders may maintain with the corporation without jeopardizing a Sec. 302(c) election. For example, the founder may maintain an office and use...