S corporation current developments: S corporation eligibility, elections and terminations; operations; reorganizations; and proposed legislative changes.

• Author: Karlinsky, Stewart S.

From a tax perspective, the period covered in this update--August 1994 through July 1995--has been an interesting one for S corporations and shareholders. Recent IRS statistics(1) presented a historical view of S tax return filings. In 1992, 1.8 million S returns were filed, representing 46.2% of all corporate tax forms. (Compare this with 1986, in which S returns represented only 24.1% of filed corporate returns.) Almost one-half of all S corporations that filed for 1992 had one shareholder; the average was 2.6 shareholders.

A recent joint Committee on Taxation study(2) of S corporations revealed that in 1993, over 1.9 million S returns were filed; almost 99% of such corporations had fewer than 1 1 shareholders and only 800 had more than 30 shareholders. Beginning in December 1995, the IRS will be conducting Taxpayer Compliance Measurement Program audits on 12,500 1994 S returns nationwide.(3)

With all these new or converted S corporations filing returns, it is not surprising that there were a number of court cases dealing with invalid filings of Form 2553, Election by a Small Business Corporation (under Section 1362 of the Internal Revenue Code), and Sec. 183 and 119 issues. There continue to be a number of letter rulings opining on proposed corporate divisions (Sec. 355) of S corporations, fewer letter rulings involving qualified subchapter S trust (QSST) beneficiaries failing to make timely elections (due to Rev. Proc. 94-23(4)), and less activity on the passive nature of rental income, due to the liberalized regulations under Sec. 1362. Of course, letter rulings are not precedential for anyone but the requesting taxpayer, but they signal the direction in which the Service is moving, and are substantial authority for taking tax return positions.

This update is presented in four major categories: eligibility, elections and terminations; operations; reorganizations; and proposed legislative changes affecting S corporations.

Eligibility, Elections and Terminations

The general definition of an S corporation in Sec. 1361 includes restrictions on the type and number of shareholders and the type of corporation that can qualify for the election. If an S corporation violates these restrictions, its S election will be automatically terminated; the taxpayer can then request a ruling under Sec. 1362(f). If the IRS rules the termination is inadvertent, the corporation retains its S status continuously., Each year, the IRS issues numerous rulings on eligibility, elections and terminations. In addition, this year, final regulations were issued relating to the definition of an S corporation under Sec. 1361.

* Shareholder eligibility

Final Sec. 1361 regulations: There are significant limitations on who can be an eligible S shareholder; final Regs. Sec. 1.1361-1, effective July 21, 1995, clarifies the definition. The issue of trusts as shareholders presents great confusion. Regs. Sec. 1.1361-1(h)(1)(v) indicates that voting trusts are permitted shareholders. In addition, Regs. Sec. 1.1361-1(j)(4) allows a qualified terminable interest property trust to function as a QSST, if it otherwise qualifies. Under Sec. 1361(d)(3), a QSST can have only one income beneficiary; Regs. Sec. 1. 1361 -1 (j) 12)(i) provides that if a husband and wife are both beneficiaries of a trust, they will be treated as one beneficiary for QSST purposes.

Regs. Sec. 1.1361-1(j)(2)(ii)(B) points out that the reasons for setting up a QSST can be crucial. If the trust is set up to provide funds for a beneficiary that are legal support obligations of the grantor, the trust does not qualify as an S shareholder. Regs. Sec. 1.1361-1(j)(8) overturns Rev. Rul. 92-84,(5) which required a QSST's current income beneficiary to recognize any gain on the sale of S stock by the trust; now, the QSST recognizes such gain. Thus, if a sale was made on the installment method, the election must be made by the trust.

Permitted shareholders under Regs. Sec. 1.1361-1(j)(2)(ii) include shareholders who have legal life estates or usufruct interests in the S stock, and, under Regs. Sec. 1.1361-1(e)(1), a partnership that holds such stock as a nominee for an individual. Regs. Sec. 1. 1361-1(g)(1)(i) clarifies the issue of nonresident alien (NRA) spouses who have a current ownership interest in the shareholder's stock under applicable local law. NRA spouses are ineligible shareholders, even if they do not directly own the stock. This provision has grave consequences for S corporations with shareholders living in community property states with NRA spouses.

Trusts: In addition to the Sec. 1361 final regulations, the IRS also issued several letter rulings concerning the eligibility of trusts. From those final regulations and past rulings, it is clear that voting trusts and revocable living trusts qualify as S shareholders, while individual retirement accounts (IRAs) do not. If S stock is transferred to a nonqualifying shareholder, the S election terminates.

In Letter Ruling 9526007,(6) a husband and wife transferred S stock to separate grantor trusts. During the grantor's lifetime, he or she will retain all rights to the trust. At death, the stock will pass to a trust for the benefit of the decedent's spouse. If there is no surviving spouse, the stock will pass to a trust for the benefit of the decedent's son; if the son dies before his parents, the stock will be distributed to a foundation. The IRS ruled that all four trusts will be eligible S shareholders. Although no ruling was requested as to the eligibility of the foundation as an S shareholder, the IRS ruled that the foundation would not qualify.

In Letter Ruling 9528008,(7) an S corporation issued shares to a stockbroker as custodian for the benefit of a shareholder; in fact, this transfer was to a self-directed IRA. The broker was not aware that IRAs are ineligible shareholders. When the S corporation hired a new accountant, he discovered the IRA shareholder; steps were then taken to transfer the stock from the IRA and reissue the stock to the shareholder individually. The IRS ruled the issuance of stock to the IRA was an inadvertent termination and the shareholder would be treated as the owner of the S stock during the period the IRA held the stock. This approach differs from the IRS position in the past; now, the IRA potentially will not be subject to unrelated business income tax (UBIT).

QSSTs: S status terminates if a QSST beneficiary does not elect to be an S shareholder, but the S corporation can request relief under Sec. 1362(f). Rev. Proc. 94-23 allows S corporations automatic inadvertent termination relief when a trust beneficiary fails to file a timely QSST election. This procedure significantly reduced the number of ruling requests. However, the IRS issued several letter rulings(8) indicating that the failure of the trust beneficiary to file a QSST election was an inadvertent termination under Sec. 1362(f). In each case, the beneficiary was not aware of the filing, requirement and a QSST election was filed as soon as the oversight was discovered.

In a related development, in Letter Ruling 9523003,(9) the IRS ruled that an inadvertent termination occurred when stock was transferred to a NON-QSST trust. In the ruling, stock was transferred to two trusts that counsel advised were QSSTs; after the transfer, proper QSST elections were filed. Later, new counsel determined the trusts did not qualify under Sec. 1361(d)(3). As soon as this error was discovered, the S stock was distributed to each of the trusts' beneficiaries. The IRS ruled that S status inadvertently terminated when the stock was transferred to the trusts, so that S status was maintained.

Number of shareholders: To maintain administrative simplicity, Sec. 1361 limits the number of S shareholders to 35. This eligibility requirement was at issue in Letter Ruling 9526021,(10) in which a group of S shareholders included a husband and wife, their seven children and 12 grandchildren. In addition, shares of the corporation were held by 14 separate QSSTs for the children's benefit. The husband planned to establish 19 additional QSSTs for the benefit of his children and grandchildren. The issue was the number of S shareholders. The IRS ruled that the 19 individuals (seven children and 12 grandchildren) would be treated as 19 shareholders even though they owned stock both individually and through QSSTs; thus, the S corporation had only 20 shareholders.

* Corporate eligibility

Affiliated corporations: To retain S status, Sec. 1361(b)(2)(a) provides that an S corporation cannot be a member of an affiliated group. This requirement applies to both domestic and foreign subsidiaries. The purchase by an S corporation of 80% or more of the stock of another corporation terminates the S election. In Letter Ruling 9524011,(11) X, an S corporation, owned less than 80% of Y corporation. As part of a plan for Y to go public, X transferred two of its divisions to Y in exchange for Y stock. After the transaction, X owned 88% of Y. Momentarily after the transfer of X's divisions, Y went public and X's...