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Current Developments (Part I) Whis two-part article on S corporation developments reviews and analyzes recent rulings and decisions. Many of the rulings continued to focus on the liberalized S provisions of the Small Business Job Protection Act of 1996. Part I addresses rulings on S eligibility, elections and terminations.
Stewart
S. Karlinsky Ph.D., CPA Hughlene
Burton Ph.D., CPA For more information about this article, contact Dr. Burton at Haburton@email.uncc.edu or Dr. Karlinsky at karlinsky_s@cob.sjsu.edu. Editor's note: Dr. Karlinsky is a member of the AICPA Tax Division's S Corporations Taxation Technical Resource Panel.
Executive Summary
The time period covered in this update—July 1, 2000 to June 30, 2001—focused on implementing the changes made by the Small Business Job Protection Act of 1996 (SBJPA). Because of the many newly created or converted S corporations, a plethora of letter rulings reflected the SBJPA changes. A new form is available to elect qualified subchapter S subsidiary (QSub) status. Also, several revenue procedures were issued as notices to address S tax-year-end changes. The Economic Growth and Tax Relief Reconciliation Act of 2001, signed into law on June 7, 2001, has little direct effect on S corporations. However, it did change some of the pension rules and may benefit S owner-employees, as well as increasing the estate tax exclusion to $1 million, reducing the estate and gift tax rate to 50% beginning in 2002 and slightly reducing the individual income tax rate (which affects entity choice). Accrual-basis S corporations' ability to use the installment method was probably a more dramatic change. The IRS will host a small business Website to share with practitioners and their clients important rulings, court cases, etc. that affect their businesses.1 Also, the IRS Strategic Plan for Fiscal Years 2000–2005 includes matching 100% of Schedules K-1 to individual returns and scrutinizing passthrough entities for noncompliance; there has been rapid growth in the number of and income from such entities.
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 entity can request an inadvertent-termination ruling under Sec. 1362(f) and, subject to IRS approval, retain S status continuously. The IRS, at the urging of Congress, has been very lenient in grant-ing inadvertent-termination relief. Prior to the SBJPA, the IRS had no authority to allow late S elections. Sec. 1362(b)(5) empowers the IRS to correct late-filing errors in electing S status if the taxpayer shows that the mistake was inadvertent, the entity qualified to be an S corporation and reported as though it were an S corporation. A plethora of inadvertent-election rulings continues, despite several procedures designed to reduce the need for letter rulings.
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) 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,2 the IRS granted S status from date of incorporation, even though it had no record of receiving Form 2553 and no proof the taxpayer mailed it. From past experience, the IRS has been more lenient than the courts in granting S status. Thus, a taxpayer is better off if a mistake is corrected before audit. It would appear that a tax adviser can achieve a better result by complying with a published procedure or requesting a letter ruling as soon as the mistake is noted, rather than waiting for an audit.
Late Elections Rev. Proc. 98-553 grants S corporations a 12-month extension to file Form 2553 without obtaining a letter ruling, thus avoiding the user fee. However, the IRS continues to receive numerous ruling requests4 on Form 2553 late filing. 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 many cases, relief was granted without the taxpayer stating the reason for failing to file Form 2553 timely.5 A number of late-election rulings6 involved a lapse in communication between an attorney and accountant as to who was to file Form 2553 for the new company; as a result, no one filed the form. In other cases,7 Form SS-4, Application for Employer Identification Number, or Form 1120-S, U.S. Income Tax Return for an S Corporation, had been filed indicating the corporation was an S corporation; however, Form 2553 was never filed. In Letter Rulings 2001060268 and 200051030,9 Form 2553 was prepared, but not mailed. In Letter Ruling 200047031,10 the taxpayer registered with the state of incorporation, but did not file Form 2553. The taxpayer stated it believed registering with the state as an S corporation was all that was needed. In each instance, the Service granted relief. In Letter Ruling 200105056,11 the taxpayer stated it had no knowledge of the Form 2553 requirement and was granted relief. In other rulings, a general manager, lawyer, accountant, tax preparer or financial consultant forgot to complete or mail Form 2553, but the company filed a Form 1120-S and the shareholders included the income on their individual returns.12 The IRS allowed S status from the company's inception in all cases.
Who Should Sign Form 2553? A question sometimes arises as to who must sign Form 2553. Per Sec. 1362(a)(2), all shareholders who own stock on the date of the election must sign Form 2553. 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 also sign. If an election is made under Rev. Proc. 98-55, the taxpayer should make sure that all affected shareholders sign Form 2553. Given that this election may be made much later than 21/2 months after the beginning of the year, many more signatures may be required. Thus, if a corporation wanted to elect S status for calendar-year 2001, Form 2553 was due March 15, 2001. However, if the corporation failed to file the form timely, under Rev. Proc. 98-55, it has up to 12 months to do so. If the form was filed on Sept. 15, 2001, all shareholders from Jan. 1, 2001–Sept. 15, 2001 had to sign Form 2553, even if they did not own stock when Form 2553 was filed. The same signing requirement applies to elections made based on letter rulings that grant S status from inception. If a taxpayer is a resident of a community property state, the S corporation should ensure that the spouses are qualified shareholders and that they sign the election form. If a spouse is a nonresident alien, it is possible to make a dual-resident status election to be a qualified shareholder. Another issue that often arises is who must sign Form 2553 for a trust that is a qualified shareholder. The trust beneficiary or his legal representative should sign the form, not the trustee (except for an electing small business trust (ESBT), for which the trustee signs the form). The same is true when filing a qualified subchapter S trust (QSST) election. In Letter Ruling 200051014,13 an S corporation had eight shareholders; two of them owned stock as joint tenants. Only one of the two joint tenants signed Form 2553 when it was filed. Because not all the shareholders signed the form consenting to S status, the election was not valid; S status terminated. The Service found the termination inadvertent and allowed the corporation to retain S status from inception.
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 IRS's satisfaction. In 2001, the IRS issued two proposed procedures to adopt, change or retain a year-end. The first, Notice 2001-34,14 grants approval for taxpayers to adopt, change or retain an annual accounting period based on considerations other than a natural business year, if specified conditions are met to offset any substantial distortion of income due to the change. S corporations can obtain approval for an accounting-period change by either establishing a business purpose under one of three enumerated tests or by meeting a facts-and-circumstances test. The three tests are the annual-business-cycle test, the seasonal-business test and the 25%-gross-receipts test. This ruling allows corporations with a seasonal business to choose a fiscal year-end, even though they cannot meet the 25%-gross-receipts test. A companion proposed procedure, Notice 2001-35,15 liberalized how passthrough entities obtain automatic approval to adopt, change or retain their annual accounting periods. The new rules would allow automatic approval in more 52-53-week-year circumstances. The proposed procedure would apply when a passthrough entity changed from a permitted tax year to a 52-53-week year with the same month-end, or changed to or retained a natural business year that meets the 25%-gross-receipts test or to a 52-53-week year that refers to that year, etc. (Historically, a 52-53-week year has applied to retail stores.)
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. In two related rulings,16 an S corporation proposed to enter into an E reorganization, under which the shareholders would receive one share of voting and 10 shares of nonvoting common stock for every share of voting stock currently owned. The only distinction between the two types of stock would be the voting rights. The Service concluded that the newly issued stock would not result in two classes of stock under Sec. 1361(b)(1)(D). Because the recapitalization met the exception in Regs. Sec. 25.2701-1(b)(3), the new stock received would not be a gift. In Letter Ruling 200029050,17 an employee-shareholder entered into an agreement with an S corporation under which he would receive nonvoting stock. The agreement provided that the corporation was obligated to buy the stock back if certain events occurred. A higher buyback price would obtain if the buyback was "non-voluntary" (i.e., triggered by death or disability, divorce, termination of employment by the company without just cause or termination of employment by the employee with just cause). "Voluntary" events included termination of employment by the employee without just cause or termination of employment by the company with just cause. The agreement did not affect dividend distributions or liquidation proceeds, which were identical for all stock. The Service ruled that the restrictions placed on the nonvoting stock by the employment agreement were to be disregarded in determining whether the company's shares conferred identical rights. An employment agreement is not a governing provision. Thus, if distributions and liquidation proceeds are equal, an S corporation should not have a second class of stock. When the S election was made in Letter Ruling 200125061,18 the corporation's charter contained dividend and liquidation preferences for the holders of specific stock. However, distributions had been made without regard to these preferences; no liquidating preferences had been paid. When the S corporation's advisers learned about the special preferences, the charter was amended to eliminate preferences on stock. The Service found that the S election had been invalidated; however, it was inadvertent, allowing the corporation to maintain S status from the date of the original election. Likewise, in Letter Ruling 200125091,19 a corporation made disproportionate distributions to a shareholder. All corporate income and expense items were allocated based on the shareholders' pro-rata stock ownership. When the shareholders later determined the disproportionate distribution might terminate the company's S election, remedial distributions were made to the other shareholders. The IRS concluded that because the stock had identical distribution rights, the timing difference did not cause the corporation to have more than one class of stock or terminate the S election. In Feraco,20 a father and son owned an S corporation. Although a third taxpayer had an option to buy stock, no stock was ever issued to him. However, he did receive a Schedule K-1 each year that listed him as a shareholder. The Tax Court ruled that even though he lacked legal title to the shares, he had consistently been treated as a shareholder and had to report his share of the corporation's income. The court reasoned that he had beneficial ownership in the S corporation because he was listed as a shareholder on Schedule K-1 and held executive positions more typical of an owner than an employee. 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 may create a second class of stock. This question is under study by the IRS; in the interim, the issue has been added to its no-rulings list.21 In Letter Ruling 200041012,22 an S corporation sought to convert to a limited partnership to reduce state franchise tax. On conversion, each partnership unit held by the partners, both general and limited, carried the same economic rights. The partnership then elected to be an association taxable as a corporation. Because the company thought the conversion would be treated as an F reorganization and its S election would not be affected, the partnership did not file a new Form 2553. Later realizing that the conversion to a limited partnership might terminate its S election (more than one class of stock), the company converted back to a corporation. Because the Service has not resolved the issue of whether a state-law limited partnership electing to be taxed as a corporation has more than one class of stock, the ruling did not address that issue. However, the Service did rule that if the conversion from a corporation to a state-law partnership did create a second class of stock, the termination of the company's S status was inadvertent. Thus, the company could retain its S status while it was a state-law partnership taxable as a corporation. Because the corporation was treated as an S corporation from inception, it did not have to wait five years before re-electing S status. According to the above ruling, general and limited partnership interests are not different classes of stock, as long as they have equal distribution and liquidation rights. The corporate equivalent would be one class of stock, despite some shareholders guaranteeing corporate loans and some not.
QSubs The SBJPA did not specify the filing requirements for electing QSub status. Last year, Sec. 1361 final regulations were issued to assist taxpayers in making a valid QSub election.23 Regs. Sec. 1.1361-3 requires an S corporation to file a QSub election with the Service Center in which the subsidiary filed its most recent tax return. The election is to be filed on Form 8869, Qualified Subchapter S Subsidiary Election. As a result, Form 966, Corporate Dissolution or Liquidation, is no longer used for a QSub election.24 Late filing: With the modification of Sec. 1361(b)(2) to allow affiliated groups, and the addition of Sec. 1361(b)(3) to allow QSubs, there has been a dramatic decrease in affiliated-group rulings. In its place there were numerous QSub late-election rulings. In Letter Ruling 200105028,25 an S corporation exchanged its stock for stock in three other S corporations, all of which became QSubs. The S corporation wanted to make a QSub election for each of the subsidiaries and relied on its tax adviser to file the appropriate forms. However, Form 966 was never filed. The Service granted an extension of time to file the election under Regs. Sec. 301.9100-3; the company was allowed to file a new Form 8869 and make a QSub election for each of the acquired subsidiaries. Likewise, in Letter Ruling 200026014,26 a trust owned two S corporations. To consolidate business operations, it created a new S corporation and contributed to it all of the S corporations' stock. The parent also set up another new corporation at the same time. A valid QSub election was filed for the new subsidiary. However, no QSub election was filed for the two existing S corporations, even though the parent intended to qualify them as QSubs. The IRS found that Regs. Sec. 301.9100-3 was met and granted the parent a 60-day extension from the date of the letter ruling to make the QSub election for the two companies, effective as of the date of the original transfer. A QSub election is needed for both new and existing S corporations that become S subsidiaries.
E&P Issues If an S corporation has accumulated subchapter 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 the 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, Sec. 1375 imposes a tax on excess net PII (as defined in Sec. 1375(b)(1)). Most of the rulings dealt with whether rental real estate activities were active or passive for Sec. 1362(d)(3)(C) purposes. Regs. Sec. 1.1362-2(c)(5)(ii)(B) requires either significant services to be performed or significant costs to be incurred to elevate an activity to nonpassive. Many rulings27 addressed rentals from industrial buildings, apartment complexes, commercial buildings, boat slips, manufactured home parks and farms and concluded the income was active. In Letter Ruling 200106030,28 an S corporation owned two QSubs. Each QSub, in turn, owned a QSub. Together, the two third-tier corporations (QSubs 3 and 4) owned rental property through a real estate partnership (see Exhibit 1). Those corporations used an unrelated management company to manage the property and an unrelated service contractor for maintenance. The corporation's employees worked with the manager to oversee the operations. The Service found that the corporations incurred significant costs in this venture and ruled that the S 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.
Several PII cases did not deal exclusively with rental real estate. In Letter Ruling 200027037,29 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 that the corporation's distributive share of the PTP's gross receipts would be included in its gross receipts from oil and gas activities, but would not be characterized as PII. A similar outcome occurred in Letter Ruling 200125089,30 in which the Service concluded that an S corporation's share of the gross receipts from a PTP attributable to purchasing, gathering, transporting, trading, storing and reselling crude oil, refined petroleum and other chemical products was not PII. In Letter Ruling 200102024,31 an S corporation owned an interest in a limited liability company (LLC) engaged in commercial general contracting, an active trade or business. The IRS determined that the S corporation's share of the LLC's income was not PII. Again, the Service used the aggregate theory and treated the S corporation as if it were in the general contracting business. An unusual situation occurred in Letter Ruling 200049018,32 in which an S corporation that owned and operated radio stations entered into a multi-year agreement with a programming firm for the latter to operate some of them. The firm would pay the S corporation a monthly fee. At the end of the agreement period, the firm could buy the stations for a set price. The S corporation had full authority over the stations' operations until the programmer exercised its rights to buy them. The IRS found that the S corporation was in an active trade or business and that the monthly payments from the programmer were not PII.
Shareholder Eligibility Sec. 1361(b) restricts S ownership to U.S. citizens, resident individuals, estates, certain trusts described in Sec. 1361(c)(2) and certain tax-exempt organizations described in Sec. 1361(c)(6). Each year, numerous rulings address inadvertent termination when an ineligible shareholder has acquired S stock. In Letter Ruling 200050018,33 an S corporation transferred its stock to three C corporations for property, thereby terminating its S election. The S shareholders did not know that a C corporation was an ineligible S shareholder. When the S corporation realized stock had been transferred to a C corporation, the stock was redeemed at the original purchase price. The IRS ruled the termination inadvertent; the S corporation could retain its status. In addition, the portion of the S corporation's income originally allocated to the C corporations had to be reallocated to the other shareholders as though the ineligible shareholders had never owned the stock. After the SBJPA, a Sec. 501(c)(3) tax-exempt organization can own S stock. In Letter Ruling 200050021,34 an S shareholder created a private foundation intended to be tax-exempt under Sec. 501(c)(3). She then transferred S stock to the foundation, but it had not met the Sec. 501(c)(3) requirements. When the shareholder realized the foundation was not qualified, she successfully petitioned a court to set aside the stock transfer. The IRS ruled that the transfer of the stock to the foundation, an ineligible shareholder, terminated its S election; however, the termination was inadvertent and the company retained S status. The IRS required the shareholder to include the income that would have been allocated to the foundation. In Letter Ruling 200047028,35 two IRAs acquired S stock. The S corporation was unaware of a problem, because the stock registry listed the stock as being owned by the IRA account holders. On noting the error, the S corporation redeemed the stock from the IRAs. Later, however, S stock was transferred to a third IRA. When the corporation's advisers found out about the latter transfer, the IRA distributed stock to the owner in a taxable transaction. Because the issuance was not for tax avoidance or retroactive tax planning purposes, the IRS ruled the termination inadvertent; the corporation was allowed to keep its S status from the original election. The S corporation also owned several QSubs, but the IRS determined they were not affected. Tax advisers need to remind clients that IRAs cannot own S stock. In Letter Ruling 200122034,36 an S corporation established an employee stock ownership plan (ESOP) under which distributions could be made in cash or company stock. However, if stock was distributed, it immediately had to be repurchased by the company. ESOP participants could elect a direct rollover of their benefits from the ESOP to an IRA or another qualified retirement plan. The IRS ruled that the corporation's S status would not terminate if the ESOP made distributions of the company's stock in a direct rollover to an IRA, as long as the corporation immediately repurchased the stock.
Trusts An S corporation and its tax advisers must constantly monitor trust shareholders' elections, trust agreements and their subsequent modifications for compliance with the S eligibility rules. The IRS ruled in several cases whether a trust would qualify as an S shareholder. For example, in Letter Rulings 200030018 and 200030019,37 an S corporation had two classes of stock—Class A nonvoting stock and common voting stock. A shareholder created a trust to which he wanted to contribute some of his nonvoting S stock or cash. If he contributed cash, the trust would use it to purchase outstanding shares of the corporation's nonvoting stock. The Service determined the individual would be treated as the trust's owner under Sec. 674(a); thus, the trust would be an eligible S shareholder under Sec. 1361(c)(2)(A)(i). Further, because the individual could not alter, amend or revoke the trust, it would not be included in his gross estate. In effect, this ruling treats the trust instrument as an irrevocable grantor trust. Another problem encountered by trusts in the S context is that, for both a QSST and an ESBT, a separate election must be made for the trust to qualify as an eligible 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 ESBT elections in certain circumstances, but there are still many ruling requests for late trust elections. In Letter Ruling 200047030,38 the IRS granted a marital trust beneficiary an extension of time to make the election under Sec. 1361(d). The beneficiary intended to treat the trust as a QSST; the trust met all the QSST requirements, but the beneficiary failed to file the election. The IRS determined that there was good cause for the failure to make the election and granted a 30-day (not the usual 60-day) extension from the ruling date to make the election. In Letter Ruling 200026017,39 an S shareholder created a revocable trust intended to be a QSST, but no election was made. The trust did not meet the QSST requirements, but the taxpayer successfully petitioned a court to reform the trust to meet them. The IRS ruled that the transfer of the S stock to the trust terminated the S election, but the termination was inadvertent. One QSST requirement is that the trust have only one income beneficiary. Letter Rulings 200106017, 200104013 and 200104014 addressed this issue.40 In Letter Ruling 200106017, an S shareholder was a trust intended to meet the QSST requirements. The trust had one life beneficiary, unless the value of the trust dropped below a certain amount. If that occurred, the corpus could be distributed to the beneficiary or to another individual. The trust did not qualify because of the possibility that the corpus could be distributed to someone other than the current beneficiary during her lifetime. Because the trust could not qualify as a QSST, it elected to be an ESBT. The trustee successfully petitioned a court to reform the trust to allow distributions to the beneficiary only, then converted from an ESBT to a QSST. The IRS ruled that the trust could convert to a QSST without the corporation losing its S status, as long as the requirements of Rev. Proc. 98-2341 were followed. In Letter Rulings 200104013 and 200104014, grantor trusts were created to be QSSTs, but no elections were made. A provision in the trusts required all corpus to be paid at a certain time in the future. If there were no beneficiaries alive when the corpus was to be distributed, it would go to charity. The IRS ruled that the possibility of the charity receiving the property was so remote that it was not a trust beneficiary; thus, the trusts qualified as S shareholders. Similarly, in Letter Ruling 200047026,42 an S shareholder transferred stock to a trust that elected to be a QSST. However, the trust did not require annual distributions of all trust income, violating the QSST statutory requirements. When the corporation realized the problem, the trustee took immediate remedial action, which included distributing the income. The IRS ruled the S termination inadvertent. ESBTs: The IRS and Treasury issued proposed regulations and a notice on ESBTs. The proposed regulations43 offer guidance in a number of areas and replace two notices and a procedure. Specifically, the proposed rules state that an ESBT beneficiary includes any person with an interest, other than a remote contingent interest. They also define a potential current beneficiary as any person who is entitled to (or at the discretion of any person may receive) a distribution from trust principal or income.44 The proposed regulations do not allow an ESBT interest to be purchased. An interest acquired in a part-gift, part-purchase also does not qualify. The proposed rules, however, do allow a grantor trust to be an ESBT. The regulations also detail the procedure for making an ESBT election. Under the new rules, the trustee would make a single ESBT election by filing a statement with the Service Center in which the ESBT files its tax return.45 No trust documents need be attached to the election. Unlike a QSST, a protective ESBT election is not allowed. A conversion of a trust from a QSST to an ESBT (or vice versa) would require an election to be filed with the Service Center in which both the trust and the S corporation file their tax returns.46 The proposed regulations also explain how ESBTs are taxed. An ESBT would consist of an S portion, a non-S portion and, in some cases, a grantor portion. Tax items attributable to a grantor portion would be taxed directly to the deemed owner. Other items would be attributed to either the S portion (which includes the S stock) or the non-S portion (which includes all other trust assets). The S portion would be taxed under Sec. 641(c); the non-S portion would be taxed under normal trust rules. Additionally, new temporary regulations47 under Sec. 444 provide that ESBTs are not deferral entities under the rules that allow an S corporation to elect a tax year other than the required tax year. The new rules apply to tax years beginning Dec. 29, 2000; a taxpayer may voluntarily apply them to tax years beginning after 1996. Notice 2001-2548 offers guidance on ESBT estimated tax payments. Before the proposed regulations, some grantor trusts electing to be ESBTs took the position that all income was taxable to the trust and the trust made the estimated payments, not the deemed trust owner. Under the proposed regulations, the owner is taxed on the S income. The IRS has provided a method for having estimated payments made by the ESBT credited to the deemed owner as of the last day of his 2000 tax year. The ESBT must file Form 1041-T, Allocation of Estimated Tax Payments to Beneficiaries, and write "FILED PURSUANT TO NOTICE 2001-25" at the top. Other issues: There are limits on how long certain trusts may hold S stock. Under Sec. 1361(c)(2)(A)(ii), testamentary 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 Letter Ruling 200051034,49 an S shareholder created two grantor trusts. On his death, one trust was divided into three subtrusts that qualified as QSSTs. The second trust ceased to be a grantor trust, but continued to be a qualified shareholder for two years. Problems arose when the QSST beneficiaries did not make valid QSST elections; further, the second trust did not distribute the stock within two years after the grantor's death. When the mistakes were discovered, the stock was transferred to qualifying shareholders. The IRS determined the termination was inadvertent. The IRS ruled that the beneficiaries of each trust will be treated as S shareholders and must include in income their share of S income from the date the trust became an ineligible shareholder. 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 a two-year window. In Letter Ruling 200027032,50 at the time of the grantor's death, the stock in the trust was distributed to three different trusts. One qualified as a grantor trust but the other two did not, although they qualified as QSSTs. Because the trustee did not know the corporation was an S corporation, no QSST election was filed. When the mistake was discovered, the stock was distributed to individuals. The IRS ruled the transfer of stock at the shareholder's death terminated the S election, but inadvertently.
Revocations and Terminations Assuming that a revocation or termination of an S election is not deemed inadvertent, under Sec. 1362(g) a company must wait five years before it may re-elect S status. When it does so re-elect, it will be subject to Secs. 1374 and 1375 S-level taxes. Under Regs. Sec. 1.1362-5, the IRS issued two rulings51 permitting a less-than-five-year wait before re-electing S status. In the first case, a sole shareholder had elected S status and subsequently revoked the election. He later sold part of his stock; the new owners wanted to re-elect S status within five years of the revocation. The IRS ruled that they could re-elect S status, because 77% of the stock had changed hands. In the second case, a shareholder transferred some of his stock to an ineligible shareholder, which terminated the S election. The shareholder then sold the rest of his stock to other shareholders, while the ineligible shareholder became eligible. The Service allowed the corporation to re-elect S status within five years of termination.
Conclusion The first part of this two-part article has examined current developments in S eligibility, elections and terminations. The second part, in the November 2001 issue, will explore S operational issues. |
