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

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

This update on S corporation develop meets reviews and analyzes the past year's rulings and decisions. But the major development is the liberalization of the S corporation rules under the Small Business Job Protection Act, which expands the number and type of permissible S shareholders and allows S corporations to wholly own C and S corporations. This article examines various provisions of this and other new law and some of the new planning opportunities they offer.

From a tax perspective, the period covered in this update--August 1995 through August 1996--has been an eventful one for S corporations and shareholders. The enactment of the Small Business Job Protection Act of 1996 (SBJPA) expanded the maximum number of eligible S shareholders to 75, added new categories of eligible shareholders, allows the IRS to waive inadvertent errors related to the making of an S election, relaxed the 2 1/2-month rule to file Form 2553, Election by a Small Business Corporation (under Section 1362 of the Internal Revenue Code), and allows sprinkling trusts, charities and pension plans to be S shareholders; also, S corporations can now be members of affiliated groups. The Health Insurance Portability and Accountability Act of 1996 (HIPAA) also made beneficial changes for S shareholders.

Recent IRS statistics(1) presented a historical perspective on S corporation return filings. In 1993, over 1.9 million S returns were filed, representing 48% of all corporate tax returns. (Compare this with 1986, in which S returns represented only 24.1% of filed corporate returns.) Over 81% of all 1993 filed S returns reported one or two shareholders.

Last year's update article(2) discussed the IRS's proposed plan to conduct Taxpayer Compliance Measurement Program (TCMP) audits on 12,500 1994 S returns nationwide. The TCMP program was scuttled due to political pressure, lack of funds and other congressional criticisms; instead, there will be more financial status audits at the individual level.(3)

With all these new or converted S corporations filing returns, it is not surprising there were a number of court cases dealing with invalid Form 2553 filings. A number of letter rulings opined on proposed corporate divisions (Sec. 355) of S corporations, but fewer letter rulings involved the failure of qualified subchapter S trust (QSST) beneficiaries to timely elect S status (due to Rev. Proc. 94-23(4)), and fewer negative rulings were issued on the passive nature of rental income (due to the liberalized Sec. 1362 regulations). Some odd S corporation issues (e.g., regarding election mailing, debt forgiveness, passive activity loss (PAL) use and relatively liberal inadvertent terminations) arose in the past year. Another major development was the "check-the-box" proposed regulations,(5) which allow a new noncorporate entity to elect partnership, limited liability company (LLC) or C or S corporation status for tax purposes, without applying the four-factor corporate attribute test of Regs. Sec. 301.7701-2.

This update is presented in four major categories: eligibility, elections and terminations; operations; reorganizations; and new legislation. Many of the issues discussed below will be eliminated by the SBJPA when fully in effect; most of its provisions apply to tax years beginning after 1996. However, the new law will trigger a different set of S corporation issues.

Eligibility, Elections and Terminations

The Sec. 1361 definition of "S corporation" 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 one of the restrictions, S status automatically terminates; 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. With the urging of Congress,(6) the IRS has been reasonable in granting such rulings.

Filing the S Election

To elect S status, the taxpayer and all shareholders on the date of the election (as well as other affected shareholders) must timely file a valid Form 2553. To ensure receipt, the taxpayer should send the election by certified mail, return receipt requested, or by registered mail. Newly enacted Section 1210 of the Taxpayer Bill of Rights 2 allows the use of certain designated private delivery services (e.g., Federal Express, Airborne Express, DHL, United Parcel Service, etc.) to be treated as the use of regular mail for Sec. 7502 purposes.

Sec. 7502(c) and Regs. Sec. 301.7502-1 provide that a document (e.g., Form 2553) sent by U.S. registered or certified mail is deemed filed on the date of the U.S. postal service postmark stamped on the cover in which the document was mailed ("timely mailing as timely filing" rule). Under the case law "mail box rule," there is a rebuttable presumption that a document deposited in a U.S. mailbox, properly addressed, placed in a sealed envelope and bearing sufficient postage, is received by the IRS. The Sixth Circuit in Miller(7) and the Second Circuit in Deutsch(8) have held that only Sec. 7502(c) applies, while the Tax Court and the Eighth Circuit in Est. of Wood(9) and the Ninth Circuit in Anderson(10) allow either the statutory or case law doctrine to apply. Most recently, the Supreme Court denied certiorari in Carroll,(11) in which the Sixth Circuit agreed with the Second Circuit's decision in Deutsch, and disagreed with Est. of Wood and Anderson, holding that use of regular mail without additional proof of mailing is insufficient to prove timely filing of an S election.

Corporate Eligibility

Sec. 1361(b)(1)(D) bars an S corporation from issuing more than one class of stock; according to Regs. Sec. 1.1361-1 (1) (1), classes of stock differ if they have different rights to distribution and liquidation proceeds. In Letter Ruling 960SO12,(12) an S corporation issued preferred stock to its shareholders. After the shareholders were informed that this was an impermissible second class of stock, it was eliminated, and inadvertent termination relief was requested and granted under Sec. 1362(f). The ruling does not specify how the preferred stock was eliminated; an "E" reorganization generally results in more benign tax effects than does a Sec. 302 redemption.

Sec. 1361(b)(2)(A) prohibits an S corporation from being a member of an affiliated group (i.e., owning 80% or more of the stock of another corporation). In Letter Ruling 9601049,(13) S corporation X created a wholly owned subsidiary, Y, to protect itself from a lawsuit; X transferred assets to Y, which then conducted business. Three years passed before it was discovered that X's S status had technically terminated. The IRS granted inadvertent termination relief and ruled that any distributions from Y to X during the inadvertent termination period constituted income to X's sole shareholder.

In Letter Ruling 9609022,(14) S corporation X bought 100% of the stock of Y, a foreign corporation. (Presumably, X thought it could hold foreign stock because the consolidated return rules do not apply to foreign corporations, under Sec. 1504(b).) When it was discovered that S status had terminated, because X was a member of an affiliated group, it sold 50% of its Y stock and requested inadvertent termination relief, which was granted. The result was the same in Letter Rulings 9626025(15) and 9625041,(16) addressing timely corrected affiliated group stock ownership.

In Letter Ruling 9626031,(17) S corporation X owned 92.5% of an LLC that owned 79% of C corporation Y. The LLC proposed to buy the remaining 21% of Y The IRS ruled that, assuming the nominal owners are the real owners, there is no affiliated group, because X did not directly own 80% or more of Y.

The IRS had ruled in Letter Ruling 9211027(18) that a certain bank could elect S status. Letter Ruling 9602029(19) revoked it prospectively, ruling that Secs. 1361 (b)(2)(B) and 585 apply, whether or not the bad debt reserve method is allowed or used.

One of the basic eligibility requirements for S status is that there cannot be more than 35 shareholders, according to Sec. 1361(b)(1)(A). In Letter Ruling 9611020,(20) an S corporation had 36 shareholders, because one...