Saving the S election; an analysis of recent letter rulings suggests that the IRS has been reasonable in granting waivers of S termination.

• Author: Wilguess, John H.

Before the Subchapter S Revision Act of 1982 added the inadvertent termination rules to the Code, errors that caused a violation of the S corporation requirements resulted in the loss of the S election. For years after Dec. 31, 1982, Sec. 1362(f) alleviates this harsh result by allowing the IRS to waive an unintentional loss of the S election. If the IRS decides that an election was lost because of a mistake that was not motivated by tax avoidance, the disqualifying event may be treated as if it did not happen. Thus, an error should no longer be viewed as fatal to an S election.

The waiver of inadvertent S terminations has been the subject of many IRS letter rulings. This article will examine the inadvertent termination rules and letter rulings on requests for waivers of terminating events. The letter rulings have been categorized to point out the types of errors that advisers should watch for to protect their clients' elections and avoid practice problems for themselves.

Inadvertent Termination

No matter how carefully a corporation monitors its qualifications to retain an S election, a terminating event (event) may happen to cause an unintentional loss of S status. The legislative history of Sec. 1362(f) indicates that when tax avoidance would not result from continuing the election, the IRS should be reasonable in granting waivers of S terminations. (1) Congress also recognized that when waiving terminations, it might be necessary for the IRS to work out agreements to protect the revenue without imposing an undue hardship on the taxpayers.

* Terminating events subject to waiver

An S election will terminate if the S corporation violates the small business corporation requirements (2) or fails the passive investment income test. (3) Loss of the S election may be avoided, however, under the inadvertent termination provisions of Sec. 1362(f). This benefit is not available if the election is voluntarily revoked under Sec. 1362(d)(l) or if the corporation fails to use a permitted year required by Sec. 1378.

The restrictive requirements placed on a trust present special problems. Certain trusts that are initially eligible, but hold an S corporation's stock longer than the 60-day or two-year grace period, (4) become ineligible S shareholders. In addition, a trust that does not satisfy all the requirements to be a qualified subchapter S trust (S trust) will be an ineligible S shareholder. (5) A violation of the requirements placed on a trust also may be subject to the Sec. 1362(f) termination waiver.

* Waiver requirements

The IRS may waive an event if three conditions are satisfied: the event must be inadvertent, it must be corrected and adjustments for the waiver period must be accepted.

A corporation may obtain a waiver by filing a ruling request. (6) The request should state the effective date of the S election; the facts about the event; why it should be considered inadvertent; when and how it was discovered; and the steps taken to return to S status.

The IRS must determine that the termination was inadvertent. Since the burden of proof is on the corporation, it must provide sufficient information to establish that the event was unintentional. (7) The corporation's position could be supported by showing that the event was not reasonably within its control, and that neither the corporation nor its shareholders had a plan to terminate the election. The corporation's position could be strengthened by showing that although it exercised due diligence to protect against a termination, the event happened without its knowledge.

Within a reasonable time after discovering the event, the corporation must take steps to requalify as an S corporation. The discovery of an event occurs when the corporation has actual knowledge of the event or when a reasonable person would know about the event. Before a waiver can become effective, there must be a complete correction of the event.

Prop. Regs. Sec. 1.1362-5(d) cites examples of possible corrections: If more than one class of stock is issued, the second class must be eliminated. When stock is owned by an ineligible shareholder, the interest must be terminated. If the passive investment income test is failed, either the passive investment income must be reduced or C earnings and profits (E&P) eliminated.

* Waiver period

The IRS's determination ruling states the period for which the terminating event will be waived (waiver period). During the waiver period, the IRS usually treats the corporation as though the event did not happen and the S election is allowed to continue without interruption. However, the IRS could limit the waiver period by making it retroactive only to the date the corporation requalified for S status. Thus, a limited waiver would result in C corporation treatment during the disqualification period.

* Adjustment consent

To receive approval of the waiver request, the corporation and all its shareholders at any time during the waiver period must agree to make adjustments consistent with S corporation treatment. An interesting result of this requirement is that ineligible entities may be treated as qualified S shareholders during the waiver period. (8) The IRS also may require adjustments to prevent the loss of revenue. Under Sec. 7121, these adjustments may be included in a closing agreement.

Prop. Regs. Sec. 1.1362-5(e) sets out the information needed in the corporate and shareholder consents. Both consents must state the adjustment required by the IRS and the waiver period, and must be signed. The shareholder consent is signed by the shareholder. It must give both the shareholder's and corporation's name, address and identification number, and state the number of shares and the dates the shareholder owned the stock. The corporate consent is signed by the person authorized to sign the corporate return. It should show the corporation's and each shareholder's name, address and identification number. The consents are to be attached to the return for the period for which the adjustments are made.

IRS Letter Rulings

An analysis of 292 letter rulings issued after 1982 on inadvertent terminations shows that over 85% of the events were due to three causes. (9)

The leading cause was the failure of an S trust beneficiary to file the required Sec. 1361(d)(2) election, followed by stock issued to an ineligible shareholder, and the S corporation becoming a member of an affiliated group. None of the letter rulings related to exceeding the 35-shareholder limit. Based on the types of events occurring, it appears that an S corporation needs to work very closely with its tax advisers when a shareholder is any type of entity other than a person and when it intends to acquire stock in another corporation.

In almost one-half of the letter rulings, the taxpayer was relying on professional advice when the event happened. As noted above, the S trust election, an ineligible shareholder and an affiliated group accounted for most of the occurrences.

The IRS has not indicated what it considers a timely correction of an event or how it determines the length of the waiver period. Based on the letter rulings, the IRS usually waives the termination back to the date of the event (S treatment does not stop). Although the average period was about 385 days, the longest waiver period in the letter rulings reviewed was 2,102 days. (10)

Failure to File S Trust Election

The most frequent event was the failure of S trust...