Current Developments (Part I)

This two-part article on S corporation developments reviews and analyzes the recent past's rulings and decisions. Many of the rulings continued to focus on the liberalized S provisions incorporated into the Small Business Job Protection Act of 1996. Part I addresses rulings on S eligibility, elections and terminations.

Hughlene Burton, Ph.D., CPA
Assistant Professor of Accounting
University of North Carolina—Charlotte
Charlotte, NC

Stewart S. Karlinsky, Ph.D., CPA
Graduate Tax Director
San Jose State University
San Jose, CA

Editor's note: Dr. Karlinsky is a member of the AICPA Tax Division's Corporations & Shareholders Technical Resource Panel. For more information about this article, contact Dr. Burton at Haburton@email.uncc.edu or Dr. Karlinsky at karlinsky_s@cob.sjsu.edu .

Executive Summary

• The IRS has been more liberal than the Tax Court in granting inadvertent termination relief.

• In 1997, for the first time, more S than C returns were filed.

• There is an increased focus on estate planning with S corporation trusts.

 

The time period covered in this update—July 16, 1999 to June 30, 2000—continued to focus on implementing the changes made by the Small Business Job Protection Act of 1996 (SBJPA). Three sets of final regulations were issued, dealing with qualified subchapter S subsidiaries (QSubs), and passthrough and adjusted basis issues. Because of the many newly created or converted S corporations, many letter rulings reflected the 1996 legislative changes. With the economy booming, there was also an increased focus on estate planning with S corporation trusts.

As will be discussed in Part II of this article, in the November 2000 issue, S operational issues continued to be addressed by the courts and Treasury, including nine cases on cancellation of debt (COD) income and its effect on an S shareholder's basis for loss. Three cases held that the statute supports a basis increase, three held it does not and three held that suspended losses may be useable in the future. This conflict should provide substantial authority when taking reporting positions and may warrant filing amended returns for open tax years. However, recent final regulations¹ specifically state that COD income is not tax-exempt income; thus, it does not increase stock basis for loss purposes. The Supreme Court will hear oral argument in one case²; thus, there may soon be closure on this important issue. Other loss issues are also discussed, as well as the effect of several cash-method accounting cases; their importance is heightened by the 1999 law change forbidding installment sale treatment for accrual-basis taxpayers. Also addressed is Rev. Proc. 2000-22,³ which permits certain entities to automatically use the cash method of accounting, if they meet a financial statement conformity requirement.

Several recent studies⁴ have examined the relative and absolute numbers of S corporations being formed vis-a-vis partnerships, limited liability companies (LLCs) and C corporations. Contrary to some commentators' predictions, C and S corporate formations outnumber LLC formations by about two to one. The LLCs have appeared primarily in the real estate and professional service markets; the S corporation clientele has been much broader. For 1997, 1.755 million partnership returns were filed, compared to 2.45 million S returns. That year (and for the first time), more S returns than C returns were filed.

Eligibility, Elections and Terminations

The general definition of an S corporation in Sec. 1361 includes restrictions on the type and number of shareholders, as well as the type of corporations, that qualify for S status. If an S corporation violates any of these restrictions, its S election automatically terminates. However, the taxpayer can request an inadvertent termination ruling under Sec. 1362(f) and, subject to IRS approval, retain its S status continuously. The IRS, at the urging of Congress, has been reasonable in granting inadvertent termination relief. For the period covered, no rulings failed to grant Sec. 1362(f) relief.

Prior to the SBJPA, the IRS had no authority to allow late S elections. Sec. 1362(b)(5) currently gives the IRS the power to correct inadvertent errors in electing S status if the taxpayer shows that the mistake was inadvertent and the entity qualified to be an S corporation and reported as though it were an S corporation.

A plethora of inadvertent election rulings were issued in the period covered, despite several recent procedures⁵ designed to ameliorate the need for rulings.

Elections

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) must timely file a valid Form 2553, Election by a Small Business Corporation (under section 1362 of the Internal Revenue Code). This election should be sent by certified mail (return receipt requested), registered mail or a pre-approved private delivery service (e.g. Federal Express, Airborne Express, DHL or UPS).

In several recent letter rulings,⁶ the IRS granted S status from date of incorporation, even though it had no record of receiving Form 2553 and there was no proof the taxpayer mailed it.

However, in two similar Tax Court cases, a late S election was disallowed. In Avula,⁷ the taxpayer deducted losses from an S corporation. The corporation had never filed Form 2553 and the taxpayers produced no evidence explaining why. At trial, the taxpayer asserted that the form had not been filed "for ethical reasons." The Tax Court denied the election and disallowed the losses.

In Barber,⁸ the taxpayer deducted losses from an S corporation. However, the IRS had no Form 2553 on file. The taxpayer maintained he had mailed the form by regular mail. The Tax Court denied the election in the absence of proof of mailing. This case points out the importance of mailing all correspondence to the IRS by registered or certified mail.

These results also indicate that a taxpayer may be better off correcting a mistake before audit. A tax adviser may achieve a superior result by requesting a letter ruling when an error is noted, rather than waiting for an audit.

Late Elections

Rev. Proc. 98-55⁹ granted S corporations a 12-month extension to file Form 2553 without obtaining a letter ruling and incurring a user fee. However, in the period covered, the IRS continued to issue numerous letter rulings¹⁰ allowing late S election filing under Sec. 1362(b)(5), if the taxpayer filed a valid Form 2553 within 60 days of the ruling. In many cases, relief was granted without the taxpayer stating why Form 2553 was untimely filed.¹¹ A number of rulings¹² involved a lapse in communication between the attorney and accountant as to who was to file Form 2553 for the new company; as a result, no one filed it.

In another case,¹³ Form SS-4, Application for Employer Identification Number, and Form 1120S, U.S. Income Tax Return for an S Corporation, had been filed, indicating that the corporation was an S corporation. However, Form 2553 was never filed. In Letter Ruling 200013040,¹⁴ the taxpayer stated he believed Form SS-4 was all that was needed. In both instances, the IRS granted inadvertent election relief.

In other rulings,¹⁵ a general manager, attorney, accountant, tax preparer or financial consultant forgot to mail or complete Form 2553, but the company filed an 1120S and shareholders included the income on their individual returns. The IRS allowed S status at the company's inception in these cases.

In Letter Ruling 200012075,¹⁶ Form 2553 was prepared, but not mailed; in Letter Ruling 200010044,¹⁷ the taxpayer stated he had no knowledge of the Form 2553 requirement. Inadvertent election relief was nevertheless granted.

Who Signs Form 2553?

A question that sometimes arises is who must sign Form 2553. Under Sec. 1362(a)(2), all shareholders who own stock on the date of the election must sign it. If the election is to be retroactive to the beginning of the year, Sec. 1362(b)(2)(B) requires all who owned stock that year (before the election) to sign.

If an election is made under Rev. Proc. 98-55, all affected shareholders must sign Form 2553. Given that the election may be made much later than 21/2 months after the beginning of the year, many more signatures may be required. For example, if a corporation wanted to elect S status for calendar year 2000, Form 2553 was due March 15, 2000. However, if it failed to timely file the form, under Rev. Proc. 98-55, it has up to 12 months to file it. Thus, if the form is filed on Oct. 10, 2000, all shareholders from Jan. 1, 2000–Oct. 10, 2000 (inclusive) must sign it.

Also, if some shareholders are residents of community property states, their spouse must also sign the election. If the spouse is a nonresident alien, other problems may arise (discussed below). The same signing requirement is applicable for elections made under letter rulings that grant S status from inception.

Another issue is who must sign Form 2553 for a trust. The trust beneficiary or his legal representative should sign the form, not the trustee. The same is true when filing a qualified subchapter S trust (QSST) election.

In Letter Ruling 200025034,¹⁸ three brothers' families owned stock. A family dispute arose that threatened to destroy the company. Two of the brothers sued under a state statute to compel the company to redeem the dissident family's stock. The remaining shareholders wanted to make an S election. Because there was a disagreement about the redemption price, a court decision was required, which occurred after the due date of Form 2553. The IRS held that, because the dissident shareholders had an irrevocable right to receive a redemption and were required by law to redeem their stock, they were not bona fide shareholders; thus, their signatures were not required on the S election form.

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 differing economic rights (to distributions and liquidations), rather than different voting rights. In Letter Ruling 200007016,¹⁹ a corporation filed Form 2553. However, at the time of the election, the corporation was ineligible to be an S corporation, because it had a second class of stock. It eliminated the second class of stock shortly after the election. Although the IRS ruled that the election was ineffective, it was inadvertent under Sec. 1362(f); the corporation was allowed S status from the election's effective date.

Likewise, in Letter Ruling 9944030,²⁰ a corporation issued preferred stock to an unrelated party for no consideration as a "purely ceremonial gesture." The corporation then elected S status. After the election, the preferred stock was converted to common. The IRS ruled that the election was ineffective but inadvertent; the corporation was treated as an S corporation from the effective date of the election. In addition, the new shareholder was not considered a shareholder until the stock was converted to common. Therefore, the original owner was considered to own all the stock (both common and preferred) before the conversion; thus, he had to include all the income on his individual return. For planning purposes, an E reorganization works well in this situation and is nontaxable; a stock redemption may be a taxable event.

In Letter Ruling 9952076,²¹ a corporation converted its preferred stock to common before the effective date of its S election. Although the corporation had only common stock, the liquidation and distribution rights were not identical for all classes. After the S election, the corporation redeemed all of one of the classes of common stock, so that all the outstanding shares had identical rights. The IRS ruled the election was ineffective, but inadvertent and, thus, valid.

In another situation,²² an S corporation made disproportionate distributions to its three shareholders over several years. The company's accountant notified it that disproportionate distributions would terminate its S election. The taxpayer then made a remedial distribution to correct the problem and filed for an inadvertent termination ruling, which the IRS granted.

In Pirro,²³ the Second Circuit ruled that an ownership interest is not the same as a shareholder interest; the corporation was not required to report ownership interests on Schedule K-1. The nature of the individual's ownership interest was not explained in the case. The IRS argued that the individual was a "beneficial" or "de facto" shareholder whose ownership percentage had to be disclosed on the S corporation's return. The court rejected this argument; it ruled that the Code does not require S corporations to report holders of unspecified "ownership interests." The court did not address whether an unspecified ownership interest would create a second class of stock.

In Rev. Proc. 99-51,²⁴ the Service stated that it would not issue advance rulings on whether a state law limited partnership is a single class of stock for S purposes. A state law partnership can elect to be taxed as a corporation. However, if it has both general and limited partners, the differences in rights and obligations may create a second class of stock. The IRS is studying the issue.

Before Rev. Proc. 99-51, the IRS ruled on the conversion of an S corporation to a state law limited partnership.²⁵ Those S corporations were allowed to convert to state law partnerships without losing S status. In each case, the partnership made a concurrent election to be taxed as a corporation.

QSubs

After the modification of Sec. 1361(b)(2) to allow affiliated groups and the addition of Sec. 1361(b)(3) (which allows QSubs), there has been a dramatic decrease in affiliated group rulings. In its place are a variety of QSub late election rulings. The issuance of Rev. Proc. 98-55, which provides a simple procedure for correcting late QSub elections, may trigger a decrease in QSub rulings and filing fees.

Making the Election

The SBJPA did not specify the filing requirements for electing QSub status. Sec. 1361 final regulations²⁶ were issued to assist taxpayers in making a valid QSub election. Regs. Sec. 1.1361-3 requires an S corporation to file a QSub election with the Service Center where the subsidiary filed its most recent tax return. The election is to be filed on a form prescribed by the IRS (not yet issued). Currently, Form 966, Corporate Dissolution or Liquidation, is to be used for a QSub election (even for a newly created subsidiary).

Regs. Sec. 1.1361-3(a)(4) adopts the proposed regulations by allowing several possible effective dates for a QSub election. The election may be made at any time during the year; in general, QSub status is effective the day the election is filed. However, the parent may specify a different effective date, as early as two months and 15 days before (or 12 months after) the actual filing. This leads to planning opportunities. For example, if a C corporation wants to convert to S status mid-year, normally the S election would not be effective until the beginning of the next year. But if, for valid business reasons, a holding company structure was required, a new company could be formed by contributing the C stock; an S election could be made for the holding company and a QSub election for the C corporation.

Late filing: Many of the covered period's rulings involved the late filing of a QSub election (despite the issuance of Rev. Proc. 98-55). In Letter Ruling 200020032,²⁷ an S corporation created a wholly owned subsidiary to improve the former's financial statement, but failed to file a timely QSub election. The IRS granted an extension of 60 days from the ruling date to make the election.

To segregate union and nonunion workers, an S corporation reorganized as a parent and two subsidiaries.²⁸ The restructuring terminated the parent's S election; it was unaware of the availability of a QSub election. A new accountant apprised it of QSub status. The IRS granted an extension for the corporation to file an S election, and QSub elections for the subsidiaries.

E&P Issues

If an S corporation has accumulated C earnings and profits (AE&P), it must carefully monitor the composition of its gross receipts, for two reasons. First, if it does not eliminate its AE&P and has excess passive investment income (PII) (i.e., more than 25% of gross receipts) for three consecutive years, S status will terminate in the fourth year. Second, a Sec. 1375 tax is imposed on excess net PII, as defined in Sec. 1375(b)(1).

Most of the rulings in this area dealt with whether rental real estate activities are active or passive for Sec. 1362(d)(3)(C) purposes. Regs. Sec. 1.1362-2(c)(5)(ii)(B) requires either significant services be performed or significant costs be incurred to elevate an activity to non-passive.

In a series of rulings,²⁹ rentals from industrial buildings, apartment complexes, commercial buildings, boat slips, manufactured home parks and farms were all deemed to be active income.

In two rulings,³⁰ an S corporation owned an interest in a real estate partnership. The IRS ruled that the corporation's distributive share of income from its partnership interest would not be PII. The IRS used the aggregate theory and treated the S corporation as though it directly owned part of the rental properties.

In another case,³¹ an S corporation owned and operated properties in joint ventures with various partnerships. The IRS determined that the income from such ventures retained its character when passed through to the S corporation. Thus, the income was not rent and not PII.

The IRS usually rules that rental income from a net lease is passive. However, in Letter Ruling 200010038,³² a taxpayer rented commercial real estate under both gross and net leases. The taxpayer provided management services and maintenance and repair of the buildings and grounds. In a departure from earlier rulings, the IRS ruled that none of the rental income was PII.

In Letter Ruling 9937037,³³ a corporation leased personal property. The taxpayer maintained sales, accounting and support maintenance staff and provided installation and removal of the leased property, repairs and upgrades. The IRS determined that the rental income was not passive, due to the significant services performed and the substantial costs incurred.

Several PII rulings did not deal exclusively with rental income. In two letter rulings,³⁴ an S corporation sought to diversify and increase its liquidity by investing in a publicly traded limited partnership (PTP) taxed as a partnership. The IRS ruled in each case that the corporation's distributive share of the PTP's gross receipts attributable to oil and gas activities would not be PII.

In four other rulings,³⁵ the IRS ruled that an S corporation's share of gross receipts from a real estate PTP would be included in its gross receipts in applying the PII limit, but the receipts themselves would not be passive.

In Letter Ruling 9937034,³⁶ an S corporation owned a limited partnership interest. The limited partnership owned a general partnership interest that it sold at a gain. Because the limited partnership interest was an investment, the taxpayer requested a ruling as to whether the gain would be PII. The IRS ruled that the corporation's distributive share of the gain on sale would not be PII, except to the extent of its share of the amount the limited partnership would have received had the general partnership sold its stock or securities at fair market value when the limited partnership sold its general partnership interest.

Two rulings addressed interest income as PII. In Letter Ruling 9938035,³⁷ an S corporation was a savings and loan holding company that owned several QSubs. Under a participation agreement, one of the subsidiaries (Bank) transferred (1) an undivided interest in loans it derived in the ordinary course of its business to one of the other subsidiaries (Sub 3) and (2) cash to another subsidiary (Sub 2). Subs 2 and 3 then formed a partnership by contributing the loans and cash received from Bank. A question arose as to the character of the interest income from the loans in the partnership, because it was not in the banking business. The IRS held that such interest income would be gross receipts directly derived in the ordinary course of a banking business and would not be PII.

In Letter Ruling 9939043,³⁸ an S corporation sold one of its properties on the installment basis. The interest income on the note exceeded 25% of the company's gross receipts for three years. Because the company had AE&P, its S election terminated in the fourth year. The IRS ruled that the termination was inadvertent under Sec. 1362(f) and allowed the retention of S status, contingent on the corporation making a distribution of the current-year AE&P to the shareholder, who had to report it. Instead of a cash payment, the corporation could have made a deemed-paid dividend under Regs. Sec. 1.1368-1(f)(3) if it had a cashflow problem.

Shareholder Eligibility

Sec. 1361(b) restricts S shareholder eligibility to resident individuals, estates, certain trusts described in Sec. 1361(c)(2) and certain tax-exempt organizations described in Sec. 1361(c)(6). Each year, many inadvertent termination rulings stem from the acquisition of S stock by an ineligible shareholder.

In several instances, a C corporation (an ineligible shareholder) acquired S stock. In Letter Ruling 200001004,³⁹ an S corporation purchased the assets of a corporation for cash and 100 shares of its stock. The stock was immediately transferred to the C corporation's shareholder. The IRS ruled that the individual shareholder would be deemed to own the stock during the time the stock was held by the C corporation. Thus, the S election was not terminated. Unless Sec. 355 applies, the distribution of stock to shareholders is generally a taxable event to both the C corporation and its shareholders.

It does not matter how little of an S corporation a C corporation owns; any ownership will terminate the S election. In Letter Ruling 200011030,⁴⁰ a C corporation merged into an S corporation. After the merger, .012% of the S corporation was owned by a C corporation, terminating the S election. When the advisers realized the problem, the stock was transferred to the C corporation's individual shareholder. The IRS ruled the termination inadvertent, allowing the S corporation to retain its election.

Because the S corporation rules are quite strict, minority or disgruntled shareholders can create potential problems. In Letter Ruling 9935035,⁴¹ two shareholders tried to transfer their S stock to a C corporation. The S corporation had a cross-purchase agreement requiring all shareholders to notify the other shareholders of any intent to sell their stock. The existing shareholders had first rights to purchase the stock. When the two shareholders tried to transfer the stock to the C corporation without notification to the other shareholders, the majority shareholder filed suit; a court declared the attempted transfer void from its inception. The IRS ruled that the attempted transfer did not terminate the S election.

An S corporation can own another S corporation (i.e., a QSub), but it must be wholly owned. In Letter Ruling 200017030,⁴² an S corporation issued another S corporation part of the former's stock, thus terminating the issuing corporation's S election. When the mistake was discovered, the stock was reissued in the name of the second S corporation's individual shareholder. The IRS ruled the termination inadvertent.

Individual shareholders must be U.S. residents. In two rulings,⁴³ stock was issued to a nonresident alien, unaware that such transfer would terminate S status. In each case, the stock was later transferred to an eligible shareholder and the termination ruled inadvertent. In Letter Ruling 9939029,⁴⁴ a nonresident alien owned stock; his wife was a U.S. citizen. The shareholder elected not to be taxed as a U.S. resident. When he found out he was an ineligible shareholder, he elected to be taxed as a U.S. resident and filed a joint return; the termination was ruled inadvertent.

Other ineligible shareholders include partnerships, LLCs, certain trusts and individual retirement accounts (IRAs). In Letter Ruling 200009029,⁴⁵ the IRS ruled that the transfer of stock to employees of a limited partnership in which the S corporation was a partner did not terminate its S election. This ruling is consistent with Regs. Sec. 1.1032-2,⁴⁶ which provides that stock may be transferred by a controlled corporation to its employees without recognizing gain or loss on the transfer.

Similarly, in Letter Ruling 200008015,⁴⁷ an S shareholder created two LLCs and two limited partnerships, into which he transferred his S stock. Each entity had elected to be a disregarded entity. Because an individual shareholder is deemed to own the stock the LLCs and limited partnerships own, the S election did not terminate. The reverse is also true. An S corporation can own a single-member limited liability company (SMLLC) that owns a stock in a QSub; alternatively, a QSub can be equally owned by an SMLLC and its owner.

In other rulings,⁴⁸ an IRA acquired S stock. On noting the error, the S corporation rescinded the IRA's stock purchase. Because the issuance was not for tax avoidance or retroactive tax planning purposes, the IRS ruled the termination inadvertent. The IRS also ruled that the IRA beneficiary was the stock's owner for the period the IRA held the stock and had to include his share of S income on his individual return. Every year, a few taxpayers seem to fall into this IRA trap. Tax advisers should warn S shareholders that IRAs cannot own S stock.

Trusts

An S corporation and its tax advisers must constantly monitor its trust shareholders' elections, trust agreements and subsequent modifications for compliance with S eligibility rules. The IRS ruled in several situations whether a trust would qualify as an S shareholder. For example, in Letter Ruling 9942037,⁴⁹ an individual set up a trust for his children, funded with S stock. The trust agreement allowed the trustee to distribute income and principal to the trust beneficiary. The beneficiary had an absolute right to withdraw all transfers of property and money made to the trust. The IRS ruled that the beneficiary was the owner of the trust's entire corpus, making the trust an eligible S shareholder. The IRS reasoned that because all contributions to the trust are subject to the beneficiary's absolute withdrawal power, she is deemed to have a power to vest the transferred property in herself within the meaning of Sec. 678(a)(1).

In Letter Ruling 9935044,⁵⁰ two S shareholders were QSSTs. However, their trust instruments did not require annual distributions of all trust income, violating QSST statutory requirements. When the corporation realized the problem, immediate remedial action was taken. The IRS ruled that the S status termination was inadvertent.

In Letter Ruling 9950018,⁵¹ two QSSTs were S shareholders; each had two beneficiaries in separately managed sub-trusts. The sub-trusts did not qualify under Sec. 1361(d)(3) as substantially separate and independent shares of trusts and could not be treated as separate trusts for Sec. 1361(c) purposes. Because the trusts had more than one current income beneficiary, they were ineligible QSSTs. When the problem was discovered, the two trusts distributed the stock to four separate trusts that were eligible S shareholders. The IRS determined the S status termination was inadvertent.

Both QSSTs and electing small business trusts (ESBTs) are eligible S shareholders. In Letter Ruling 9935043,⁵² an S corporation transferred stock to two ESBTs. Later, it was determined that trust provisions could cause the loss of S status (the trusts could have current beneficiaries that were ineligible shareholders and could result in more than 75 shareholders). When the problem was found, the trust agreement was amended to comply with the S provisions. The IRS ruled the S status termination inadvertent.

In another instance, a trust was funded with C stock. The corporation then elected S status. The trustee consented to the election and made an ESBT election. In addition, to ensure continuing S qualification, the trustee entered into a shareholder agreement with the corporation and the other shareholders. In 42 related rulings,⁵³ the IRS determined the trust was an eligible S shareholder and that the trustee's actions would not affect the quality, value or timing of any beneficial interest. Additionally, the IRS determined the transaction would not cause the trust to lose its generation-skipping transfer tax-exempt status.

In Letter Ruling 9942017,⁵⁴ an S shareholder created an irrevocable trust. The trust agreement allowed the shareholder the right and power at any time, in a non-fiduciary capacity, to withdraw any trust assets if he substituted property of equal value. The IRS ruled that the shareholder was the owner of the trust's entire corpus, because he retained the powers described in Sec. 675(2). The Service ruled that, because the shareholder owns the trust under Secs. 671–678, the trust is an eligible S shareholder under Sec. 1361(c)(2)(A)(i).

In other cases,⁵⁵ a father funded a trust with S stock. The trust agreement provided for notice to the beneficiary of transfers to the trust and a Crummy right to withdraw those gifts. None of the trust assets could revert to the grantor. Because the beneficiary had the right to withdraw gifts made to the trust, he would be treated as the trust's owner; thus, the trust was a valid S shareholder. The IRS also ruled that, absent an implied or express understanding that the beneficiary would not exercise his withdrawal rights, the gifts were eligible for the annual $10,000 per-donee gift tax exclusion and no part of the trust would be included in the father's estate.

Other types of trusts may or may not qualify as S shareholders. In Letter Ruling 200017023,⁵⁶ S stock was sold at auction to a trust that was an ineligible shareholder. When this problem was discovered, the shares were redeemed. The IRS ruled the termination inadvertent.

There are limits on how long certain trusts may hold S stock. Under Sec. 1361(c)(2)(A)(ii), trusts whose entire corpus is included in the grantor's gross estate can hold S stock for only two years after the grantor's death. In two cases,⁵⁷ a QSST continued to hold S stock beyond the two-year period. When the corporation realized the problem, the stock was distributed to the beneficiary. The IRS ruled the termination inadvertent.

It is common for wealthy taxpayers to hold assets in a revocable living trust that qualifies as an S shareholder. However, when one of the grantor/trustees dies, the irrevocable trust thereby created may have to distribute the S stock within two years. In two letter rulings,⁵⁸ a revocable living trust owned S stock. One of the grantors died; the trust became irrevocable and continued to hold stock beyond the two-year period, terminating the S election. When this mistake was discovered, the stock was transferred to an eligible shareholder; the IRS ruled the termination inadvertent.

Another problem is that for both QSSTs and EBSTs, 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. The IRS issued Rev. Proc. 98-55 to allow late QSST or EBST elections in certain circumstances, but there are still many ruling requests for late trust elections. In several letter rulings,⁵⁹ the trustee failed to file a QSST election. When this oversight was detected, a QSST election was filed. If a QSST election is not made, the S election technically terminates, because the trust is an ineligible shareholder. The IRS ruled the termination inadvertent and that the trust could be a shareholder (but not a QSST) until the election was filed.

Revocations and Terminations

Treasury issued final regulations⁶⁰ on the allocation of income in the year an S corporation terminates. According to Regs. Sec. 1.1362-3(a), the income should be allocated pro rata between the S tax year and the C tax year. In certain circumstances, the corporation can elect to allocate income and loss on the basis of its normal method of accounting under Sec. 446. However, this election can be made only if all shareholders during the S year and all shareholders on the first day of the C year consent, according to Regs. Sec. 1.1362-3(b)(1). The pro rata allocation rules do not apply to any Sec. 338 transaction or, if at any time during the S termination year there is a change in ownership of 50% or more, under Regs. Sec. 1.1362-3(b)(2) and (3).

Assuming that the revocation or termination of the S election is not deemed inadvertent, under Sec. 1362(g) a company must wait five years before it can re-elect S status. It will be subject to Secs. 1374 and 1375 S-level taxes on the re-election. Under the authority of Regs. Sec. 1.1362-5, the IRS issued two rulings permitting a less-than-five-year wait before re-electing S status. In the first situation,⁶¹ an S shareholder sold all his stock back to the company. The company later revoked its S election. The shareholder later bought 100% of the stock back without knowing of the S status revocation. The IRS ruled that the corporation could re-elect S status. In the second situation,⁶² a corporation was allowed to re-elect S status within five years because more than 50% of the stock had changed hands between the time of the S election revocation and the new election.

In Letter Ruling 9952058,⁶³ the IRS granted a waiver of the five-year waiting period. The company was a wholly owned subsidiary of an S corporation that elected to be a QSub. The company inadvertently filed Form 2553 without listing an effective date.

In Letter Ruling 200003044,⁶⁴ the IRS waived the five-year waiting period when a company merged with its QSub. An S corporation was the sole shareholder of both companies before the merger. The resulting company was allowed to elect S status.

The IRS rejected a corporation's request to re-elect S status within five years in Letter Ruling 9952072.⁶⁵ An S corporation revoked its S election, had the shareholders sell their stock to an employee stock option plan (ESOP) and sought to defer the gain under Sec. 1042, then re-elect S status. The IRS determined the proposed transaction would contravene the applicable statutes and Congressional intent. As discussed in Part II of this article, in the November 2000 issue, C shareholders should be able to sell their stock to an ESOP, defer the gain under Sec. 1042, then make an S election.

QSubs

Regs. Sec. 1.1361-3(b) prescribes procedures for revoking QSub status. The parent must file a statement including the parent's and QSub's names, addresses and taxpayer identification numbers with the Service Center where the S corporation's most recent tax return was properly filed. If the parent does not specify the date for revocation of QSub status, it will be the date the statement is filed. If the parent specifies a date, it cannot be more than two months and 15 days before (or more than 12 months after) the date the revocation statement is filed.

Under Regs. Sec. 1.1361-5(a), a QSub election terminates on (1) the date listed in the revocation statement, (2) the last day of the parent's S year (if the parent's S election terminates under Regs. Sec. 1.1362-2) or (3) when an event occurs that renders the subsidiary ineligible for QSub status. According to Regs. Sec. 1.1361-5(b), a terminated QSub is treated as a new corporation that acquired all of its assets immediately before the termination from the S parent, in exchange for stock of the new corporation. In this situation, taxpayers need to be aware there might be Sec. 357(c) gain if the QSub's liabilities exceed its aggregate assets' bases.

If a QSub election is revoked, such status cannot be re-elected for five years without IRS consent. Regs. Sec. 1.1361-5(c) allows a re-election without IRS consent if the corporation was never a C corporation after the revocation. This situation could occur, for example, if the subsidiary was spun off in a Sec. 355 transaction.

In Letter Ruling 200011024,⁶⁶ the IRS granted a waiver of this rule. The parent sought to distribute QSub stock to its shareholders in a partial redemption of parent stock, which would cause the subsidiary to lose QSub status. The IRS allowed the subsidiary to elect S status.

Conclusion

The first part of this two-part article has examined current developments in S corporation eligibility, elections and terminations. The second part, in the November 2000 issue, will explore S operational issues.