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Current Developments (Part II) This two-part article on S corporation developments reviews and analyzes recent legislation, rulings and decisions. Part II examines eligibility, elections and terminations.
Stewart S. Karlinsky, Ph.D.,
CPA
Editors note: Dr. Karlinsky is a member of the AICPA Tax Divisions S Corporation Taxation Technical Resource Panel (TRP). Dr. Burton is a member of the AICPA Tax Divisions Partnership Taxation TRP.
Executive Summary
Part I of this two-part article, in the October 2003 issue, addressed S corporation operational issues, including undercompensation issues, loss limits and corporate reorganizations. Part II, below, discusses S eligibility, elections and terminations. During the time period covered, a revenue procedure33 extended the deadline to make an S election. Part II also covers numerous letter rulings on corporate and shareholder eligibility.
Eligibility, Elections and Terminations The general definition of an S corporation includes restrictions on the type and number of shareholders, as well as the type of corporation, that can qualify for an S election. If an S corporation violates any of these limits, its S status is automatically terminated. However, the taxpayer can request an inadvertent termination ruling under Sec. 1362(f) and, subject to IRS approval, retain its S status continuously.
Elections Filing an S Election To qualify as an S corporation, the corporation and all its shareholders on the date of the election (as well as other affected shareholders) have to timely file a valid Form 2553, Election by a Small Business Corporation. They should file the election by certified mail (return receipt requested), registered mail or a pre-approved private delivery service (e.g., Federal Express, Airborne Express, DHL or UPS). The burden of proof is on the taxpayer. For example, in Martin Higbee,34 the shareholders asserted that they had mailed Form 2553, but had no proof. The court ruled that their S election was invalid. However, the Service has allowed S status in similar situations in previous letter rulings, which exemplifies that the IRS is more lenient when the issue arises before audit, rather than in the courts.
Late Elections This year, the IRS issued Rev. Proc. 2003-43,35 granting S corporations a 24-month extension to file Form 2553 without obtaining a letter ruling, thus avoiding a user fee. To benefit from this procedure, an S corporation has to meet all of the following requirements: 1. The entity has failed to timely file the appropriate election; 2. Fewer than 24 months have passed since the elections original due date; 3. The entity has reasonable cause for failing to make a timely election; and 4. The entity meets one of two sets of additional requirements. The first set requires that:
The second set of alternative requirements is:
Based on prior letter ruling requests, the second set of alternatives is the one that most taxpayers meet. Rev. Proc. 2003-43 also applies to late-filing requests for qualified subchapter S subsidiaries (QSubs), electing small business trusts (ESBTs) and qualified Subchapter S trusts (QSSTs). Even with this procedure and previous lenient ones, the IRS continues to receive numerous late-filing letter ruling requests.36 In all instances, the IRS allowed S status from inception under Sec. 1362(b)(5), as long as the taxpayer filed a valid Form 2553 within 60 days of the ruling. In a number of these situations,37 the taxpayer filed Form SS-4, Application for Employer Identification Number, and Form 1120S, U.S. Income Tax Return for an S Corporation, indicating that the corporation was an S corporation. However, the Form 2553 was not filed prior to the ruling request. In other rulings,38 a general manager, lawyer, accountant, tax preparer or financial consultant forgot to mail or fill out Form 2553, but the company filed Form 1120S and shareholders included the income on their individual returns. The Service allowed S status at the companys inception in each case. In several instances,39 entities were limited liability companies (LLCs) or limited partnerships that planned to file Form 8832, Entity Classification Election, electing to be treated as a corporation, and then file Form 2553, to be taxed as an S corporation. Despite the fact that the entities never filed either election, the Service granted them relief and allowed S status from inception, as long as both forms were filed within 60 days of the ruling.
Who Should Sign Form 2553? Per Sec. 1362(a)(2), all shareholders who own stock on the election date must sign Form 2553. If the election is retroactive to the beginning of the year, Sec. 1362(b)(2)(B) requires all who owned stock that year, prior to the election, to also sign. For example, in one ruling,40 two married couples owned an S corporation. When they filed Form 2553, the wives did not sign the form; however, the taxpayers filed their returns consistent with the company being an S corporation. The Service determined that the S election was inadvertently invalid for failure to attach certain shareholder consents to the election, allowing the corporation to retain its S status. In another ruling,41 an entity in-tended to be an S corporation, but failed to file Form 2553. An individual bought the stock from the original shareholder believing the company had a valid S election in effect. The Service granted the corporation S status from inception as long as Form 2553 is filed. Presumably, both the new owner and the original shareholder will have to sign the election, but the ruling did not address that. In another situation,42 a company filed a faulty Form 2553, specifying the wrong number of shares and the wrong acquisition date for three of the shareholders. The Service determined the errors did not render the election invalid.
Election of Year-End Sec. 1378 allows an S corporation to adopt a permitted year-end, which is defined as either December 31 or any year-end for which the corporation establishes a business purpose to the IRSs satisfaction. In one ruling,43 a C corporation had a fiscal year-end that it intended to keep when it converted to S status. However, due to an error, it did not timely file Form 8716, Election to Have a Tax Year Other Than a Required Tax Year. The Service allowed the company to retain its fiscal year-end, as long as it properly filed the form within 45 days of the ruling and made the correct payment under Sec. 444.
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 equal rights to distributions and liquidations, but not necessarily equal voting rights. The Service addressed a rather complicated transaction44 in which an S corporation wanted to restructure, using the following steps: 1. The sole shareholder would form a limited liability partnership (LLP) and a single-member LLC (SMLLC), with the SMLLC owning part of the LLP. The LLP would elect to be taxed as a corporation and make an S election. 2. The individual would contribute all the outstanding S stock to the LLP and the S corporation would make a QSub election. 3. The LLP would form a single-member state limited liability company (SLLC) by transferring a percentage of the S stock to the SLLC. 4. The S corporation would convert to a limited partnership, with the SLLC as the general partner and the LLP as the limited partner. Provisions of the limited partnership agreement would allow it to qualify as an S corporation. The Service concluded that (1) the LLP would be an eligible S corporation, (2) the partnership agreement did not create a second class of stock terminating the election and (3) the LLP could make a QSub election for the S corporation.45 A state-law partnership can elect to be taxed as a corporation. However, if the partnership has both general and limited partners, the differences in rights and obligations might create a second class of stock. The IRS is studying this question and has added it to the no-advance-rulings area. In two situations,46 an S corporation converted to a state law partnership; when it learned that the conversion might create a second class of stock, it converted back to an S corporation. The Service ruled that the temporary conversion did not terminate the initial S election. In two other instances,47 corporations had more than one class of stock, with different liquidation rights outstanding, when they elected S status. In the first instance, the board of directors amended the certificate of incorporation to eliminate any differences between the two classes of stock. In the second situation, the corporation exchanged the outstanding shares of three classes of stock for a fourth. In both cases, the Service allowed the companies to retain their S status, because the elections were inadvertently invalid. In another ruling,48 an S corporation had a policy of making distributions that covered shareholders tax liabilities. Some stock was redeemed in years 2 and 3. In year 4, the company filed an amended tax return for year 1 and made a current-year distribution for the additional taxes due from the amended return, based on year 1 holdings. The Service ruled the distribution was remedial in nature and did not create a second class of stock. In another situation,49 an S corporation obtained a commercial loan from a party regularly engaged in the business of lending money. In exchange, the corporation issued a stock purchase warrant to the lender that allowed it to acquire the S corporations stock. The warrant also contained a put option that allowed the lender to sell the warrant back to the S corporation at fair market value. The parties agreed to extend the period the lender could exercise the warrants; this extension did not create a second class of stock.
QSub Election An S corporation can own another S corporation only if it files a QSub election for the wholly owned subsidiary with the IRS campus (formerly, service center) where the subsidiary filed its most recent return. It has to file the election on Form 8869, Qualified Subchapter S Subsidiary Election, by the 15th day of the third month after the elections effective date. Many of the past years rulings50 involved a late QSub election. In each case, the Service determined that the taxpayer showed good cause for the delay and granted a 60-day extension from the ruling date to make the election.
AEP Issues If an S corporation has accumulated subchapter C earnings and profits (AEP), it has to carefully monitor the composition of its gross receipts, for two reasons. First, if it does not eliminate the AEP and has too much passive investment income (PII) (i.e., more than 25% of gross receipts) for three consecutive years, its S status will terminate in year 4. Second, Sec. 1375 imposes a tax on excess net passive income, as defined in Sec. 1375(b)(1). Most of the rulings this year dealt with whether rental real estate activities were active or passive for Sec. 1362(d)(3)(C) purposes. Under Regs. Sec. 1.1362-2(c)(5)(ii)(B), an activity is nonpassive only if the corporation performs significant services or incurs significant costs. In various rulings,51 the IRS deemed rentals from industrial buildings, apartment complexes and commercial buildings to be active income. The decision was the same whether the taxpayer owned the property directly or indirectly.52 This past year, several PII cases did not deal exclusively with rental real estate. In two rulings,53 an S corporation wanted to diversify and increase its liquidity by investing in a publicly traded partnership taxed as a partnership. The Service concluded that the S corporations share of the gross receipts from a partnership, which were attributable to purchasing, gathering, transporting, trading, storing and reselling crude oil, refined petroleum and other chemical products, was not PII under Sec. 1362. In three other rulings,54 an S corporation had AEP and excess PII for its first three years as an S corporation (unlike in the previous rulings). As a result, the S election terminated at the beginning of year 4. In that year, the corporation paid the appropriate tax under Sec. 1375 and distributed all of its AEP. The Service ruled that the termination of the companys S election was inadvertent and allowed the company to keep its S status.
Shareholder Eligibility Sec. 1361(b) restricts S share ownership to U.S. citizens, resident individuals, estates, and certain trusts and tax-exempt organizations. Each year, numerous rulings deal with inadvertent terminations when an ineligible shareholder has acquired S stock. In several instances,55 an S corporation issued shares to an ineligible shareholder and tried to remedy the problem after it discovered the mistake. The Service ruled the corporation would be treated as an S corporation as long as it corrected the error within 60 days of the ruling. In two rulings,56 an S corporation transferred shares to an LLP, which was an ineligible shareholder. After discovering the mistake, it redeemed the shares. The Service ruled the termination was inadvertent and allowed the corporation to retain its S status. However, the LLP was deemed to be a shareholder for the period it owned the S stock and was required to report its share of S income on its partnership return. In a similar situation,57 an S corporation issued shares to a two-person LLC. The LLC was not an eligible shareholder, because it could not be a disregarded entity. When the corporation discovered this error, one of the LLC members transferred his interest to the other member, thus making the LLC an eligible shareholder. The Service found that the termination of S status was inadvertent and treated the two LLC owners as S shareholders for purposes of allocating income. In a related ruling,58 a shareholder transferred his S shares to a partnership. Later, the shares were distributed back to the original owner. As with the LLC, the Service ruled that the termination was inadvertent. Likewise, when an S shareholders shares were cancelled and reissued after the corporations attorney noted that the shareholder had transferred his stock to a C corporation, the Service found59 the election termination inadvertent; the individual was treated as owning the shares the corporation had owned. In another ruling,60 an S corporation and its QSub wanted to sever ties. The S corporation planned to distribute all the QSub shares to individual shareholders. Immediately after, the QSub would make an S election. The Service ruled that the distribution of the stock would terminate the QSub election; if the S corporation distributed the stock immediately, its momentary ownership of the stock would not create an ineligible shareholder for the QSub. In another ruling,61 an S shareholder sold his interest to a nonresident alien (NRA), an ineligible shareholder, which terminated the S election. When the error was discovered, the NRA transferred the shares to his children (who were U.S. citizens). This termination was inadvertent; the company retained its S status. In three different rulings,62 IRAs acquired the stock of an S corporation. In two of these, the S corporation redeemed the stock from the IRA after the discovery; in the other, the IRA transferred the stock back to the individual shareholder. Because the issuance was not for tax avoidance or retroactive tax planning, the IRS ruled that each termination was inadvertent. In a related situation,63 an S corporation had eight shareholdersfour individuals and four ineligible IRAs owned by the individuals. The IRA shares were later transferred to an eligible shareholder. The invalid election was inadvertent; the IRS deemed the IRAs shares to be owned by the individuals for the time the IRAs held the stock. In another ruling,64 an S corporations employee stock ownership plan (SESOP) transferred shares to a participants IRA on his termination of employment. Pursuant to the SESOPs terms, the shares were to be immediately repurchased, but the repurchase did not occur until later, due to financial problems. The Service ruled that the election termination was inadvertent.
Trusts This year, the IRS ruled in several situations whether a trust would qualify as an S shareholder. In one case,65 a trust that owned shares in a corporation that elected S status did not meet the requirements for an S shareholder. Shortly after the corporation learned the trust was an ineligible shareholder, it transferred the stock to a new trust that was eligible. The Service ruled the S election inadvertently invalid, but not tax motivated. In a similar situation,66 the corporation did not treat the trust as a shareholder on the corporations tax return. The Service ruled that the termination was inadvertent, but required the corporation to reacquire the shares from the trust within 60 days and to treat it as a shareholder for the period it held the stock. In another ruling,67 two individuals created grantor trusts with S stock. The trusts were for the benefit of two other S shareholders. Later, the beneficiaries of each trust also transferred S stock into each trust, thus violating the trusts terms and making them ineligible shareholders. When they discovered the problem, the trusts transferred the stock contributed by the beneficiaries back to them, and the Service allowed the company to retain S status. Lastly, in an unusual situation,68 an eligible trust that owned S stock was divided into three separate trusts that were also eligible shareholders. The stock held by one of the new trusts was then allocated to a sub-trust. On review, an accountant determined the sub-trust was not an eligible shareholder. The sub-trust then distributed the stock to two individuals. The Service ruled that the transfer to the sub-trust terminated the S election, but the termination was inadvertent. This year, there were several instances69 in which a testamentary trust held S stock for more than the two years allowed under Sec. 1361(a)(2)(A)(iii). At the end of two years, a QSST election had to be made for the trust to continue to be an eligible shareholder. This election was not made and the trust did not distribute its income to the beneficiaries. The failure to make the QSST election and to distribute the income terminated the S election, but the IRS ruled that the termination was inadvertent. This ruling was contingent on all the shareholders treating the company as an S corporation and the trusts reporting their share of the S income on their returns. Given the small amount of undistributed trust income needed to fall into the highest marginal tax rate, this holding could be expensive. In another ruling,70 a taxpayer transferred stock to a trust that would qualify as a QSST. The beneficiary had a life estate in the trust. The Service ruled that a trust with a life tenant would be an eligible S shareholder as long as a proper QSST election was filed. Another problem for both QSSTs and ESBTs is that a separate election must be made for the trust to qualify as an S shareholder. Many times, this election is filed incorrectly and an inadvertent termination ruling is needed. This year, in numerous instances,71 a corporation intended to treat a trust as either a QSST or an ESBT and the trust met all the requirements, but the beneficiary failed to file the election. The IRS determined in each case that there was good cause for the failure to make the election and granted the beneficiary a 60-day extension from the ruling date. One requirement for a QSST is that it has to distribute all of the trusts income annually. In a series of rulings,72 an S shareholder was a trust that intended to meet the QSST requirements. However, the trust did not require annual distributions of all trust income. When the corporation realized the problem, the trustee took immediate remedial action. The IRS ruled that the termination of the corporations S status was inadvertent. In another ruling,73 S shares were transferred to a trust that properly elected to be an ESBT. Afterward, the ESBT transferred the stock to a new LLC in return for a 100% membership interest. The LLC did not elect to be taxed as a corporation. The Service ruled that the transfer of the stock to the LLC did not terminate either the S or the ESBT election.
Terminations Several situations arose this year that addressed when an S election is terminated. In Alphonse Mourad,74 an S corporation filed a bankruptcy petition. The shareholder did not report his share of S income after the corporation filed for bankruptcy. The Tax Court ruled that the bankruptcy filing did not terminate the S corporations tax status, nor did it create a new entity. Lastly, in two rulings,75 an S corporation was administratively dissolved by a state for failing to file required annual reports. The company was reincorporated in the state after it became aware of the dissolution. The IRS ruled that corporate existence for Federal tax purposes is a matter of Federal law. Thus, the administrative dissolution did not terminate the companys S election. |
