Current developments in S corporations (Part I): this two-part article discusses recent legislation, cases, rulings, regulations, and other developments in the S corporation area. Part I focuses on eligibility, elections, and termination issues.

EXECUTIVE SUMMARY

* The Small Business and Work Opportunity Tax Act of 2007 contains several provisions that affect S corporations.

* Proposed regulations were issued relating to banks that are S corporations.

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Part I of this two-part article discusses S corporation eligibility, elections, and termination issues, including several changes related to the Small Business and Work Opportunity Tax Act of 2007, P.L. 110-28 (SBWOTA), significant trust issues, and a notice relating to permitted year ends for S corporations. In addition, numerous letter rulings on corporate and shareholder eligibility will be discussed.

SBWOTA

The SBWOTA had several provisions that affected S corporations. For the most part these provisions were pro-taxpayer and, unless otherwise noted, will be effective for years beginning after December 31,2006. Some of these will be presented here and others will be discussed in Part II of the article, in the November 2007 issue.

Two provisions of the new law relate to banks that have elected to be S corporations. According to Grant Thornton, LLP, as of March 2005, 2,237 banks had switched to S corporation status. However, only banks (usually community banks) that do not use the reserve method of accounting for bad debts can elect to be S corporations. If the bank changes from the reserve method of accounting for bad debts, a Sec. 481 adjustment must be made; this adjustment generally is included in income over four years. New Sec. 1361(g) allows the bank to elect to take into account 100% of the adjustment the year before it changes to an S corporation, when it is still a C corporation. Therefore, the bank takes the adjustments into account at the entity level (where it enjoyed the benefit of the previous deduction) rather than at the shareholder level.

A second provision helpful to bank S corporations relates to bank director shares. National and state banking laws require a bank's director to own stock. In some cases, a bank will enter into an agreement in which the bank will reacquire the stock when the director ceases to hold the office. Requiring all directors to own stock could create a problem with the shareholder limit, while the repurchase agreement could create a second class of stock. Both of these issues would cause the termination of an S election. New Sec. 1361(f)(1) clarifies that qualifying "restricted bank director shares" are not recognized for any subchapter S provisions. New Sec. 1368(f)(1) also treats any distributions on this restricted stock as income to the director and deductible to the bank.

Note: An interesting question is whether this restricted-bank-director-stock-disregarded status would allow directors to own stock in a qualified subchapter S subsidiary (QSub) and not disqualify the subsidiary bank.

If an S corporation has accumulated earnings and profits (AE&P) at the end of the year and more than 25% of its gross receipts are from passive investment income (PII), the S corporation will be subject to a corporate-level tax. The 2007 act reduces the possibility of an S corporation's being subject to this tax. Under new Sec. 1362(d)(3), capital gains on stocks and securities will not be treated as PII under Secs. 1362(d) and 1375. In a related provision, the new law eliminates S corporation previously taxed income (PTI) attributable to pre-1983 years for corporations that were not S corporations for their first tax year beginning after December 31, 1996. These two provisions apply to tax years beginning after May 25, 2007.

Another new provision makes an S corporation a slightly more attractive vehicle for investments. Sec. 641(c)(2)(C)(iv) allows an electing small business trust (ESBT) to deduct any interest expense it incurs when it borrows funds to purchase S stock. This provision places an ESBT on par will all other taxpayers, including qualified subchapter S trusts (QSSTs), for the deduction. Because ESBT income is taxed at the highest individual rate, this change allows a tax deduction at a 35% tax rate.

A far more anti-taxpayer provision that affects all taxpayers (including S corporations and their shareholders, as well as tax practitioners) is the expansion of Sec. 6694, under which tax practitioners must use a "more likely than not" standard on undisclosed positions for returns prepared after May 25, 2007. (This is in contrast to the "realistic possibility of success" standard that practitioners previously used.) In addition, the amount of the Sec. 6694 penalty has been increased. The revisions to Sec. 6694 constitute major changes to practice standards and penalties that have been in place for many years. Two instances in which this new provision could affect S corporations are (1) basis in debt due to back-to back loans and (2) the calculation of built-in gain under Sec. 1374. (For more on these preparer penalties, see Tax Clinic, p. 582.)

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 may qualify for the election. If an S corporation violates any of these restrictions, 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. Congress had requested that the IRS be lenient in granting inadvertent-election and termination relief, and it is clear from the rulings presented below that the IRS has abided by congressional intent.

Elections

Late elections: In an attempt to reduce the number of late filing requests, the IRS issued Rev. Proc. 2003-43, (1) which grants S corporations, QSubs, ESBTs, and QSSTs a 24-month extension to file Form 2553, Election by a Small Business Corporation (Under Section 1362 of the Internal Revenue Code), Form 8869, Qualified Subchapter S Subsidiary Election, or a trust election without obtaining a letter ruling. It appears that the procedure is having its intended effect. Even though the IRS continues to receive a number of late-filing requests, (2) the number of letter rulings issued this year is less than half the number issued in years prior to the procedure's issuance. In all instances this year, 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, (3) the corporate minutes reflected the company's desire to be an S corporation and the corporation contended that Form 2553 had been filed, but the IRS did not have a record of its being filed. Generally in these situations, the corporation and shareholder have treated the entity as an S corporation, and the only step they have forgotten is to file the Form 2553. However, in one instance, (4) the IRS allowed S status even though a Form 1120S, U.S. Income Tax Return for an S Corporation, had not been filed. In this ruling, the Service allowed S status from the original date but required the corporation to file a Form 1120S for all years the corporation was deemed to be an S corporation, and the shareholder to file amended Forms 1040 for those years.

In some situations an entity is formed as either a limited liability company (LLC) or a limited liability partnership (LLP) but wishes to be treated as an S corporation. In the past, the entity had to file both Forms 8832, Entity Classification Election, and 2553. For elections after July 20, 2004, Treasury issued final regulations that eliminate the need to file Form 8832. Instead, a partnership or disregarded entity that would otherwise qualify to be an S corporation, and that makes a timely and valid election to be treated as an S corporation on Form 2553, will be deemed to have elected to be classified as an association taxable as a corporation. Even though Form 8832 does not need to be filed when the election is made, the corporation must attach a copy to its first tax return when filed. Nonetheless, there were still several instances (5) in which the entity was required to file Form 8832, electing to be treated as a corporation, and then file Form 2553 to be taxed as an S corporation. However, the entity failed to file either of the elections. The Service granted these entities relief and allowed S status from inception, as long as both forms were filed within 60 days of the ruling.

In one situation, (6) an LLC filed Form 8832 but forgot to file Form 2553. The company and the shareholders filed tax returns as if the company were an S corporation. The IRS determined that the S election was to be treated as timely filed if the company filed Form 2553 within 60 days of the ruling.

In another ruling, (7) a corporation intended to be an S corporation but failed to timely file Form 2553. The state in which the business was incorporated administratively dissolved the corporation for failure to file the proper reports and pay the appropriate taxes. After the dissolution, the business reincorporated. The IRS concluded that the business was a corporation for income tax purposes the entire time, even though its status was terminated by the state, and, therefore, it would treat the company's S election as timely if the corporation filed Form 2553 within 60 days of the letter ruling.

Who signs Form 2553: When a corporation files Form 2553, all shareholders must consent to the election. In a 2007 letter ruling, (8) the shareholders of a corporation intended for it to elect S status when it was incorporated. The election was not only filed late, but also failed to contain consents from all its shareholders. The taxpayer made matters worse by issuing stock to a partnership (an ineligible shareholder). However, the taxpayer realized its error and cancelled the partnership's stock. The IRS held that the failure of the taxpayer's election due to the missing shareholder consents was inadvertent and that it would allow the corporation to retain its S status, as long as Form 2553 with the signatures of all its shareholders was filed within 60 days of the ruling. It also held that the issuance of the stock to the ineligible shareholder was inadvertent.

Corporate Eligibility

Type of corporation: Sec. 1361 does not allow certain types of corporations to elect S status, including certain financial institutions, insurance companies, foreign corporations, and corporations electing Sec. 936 status. Until 2004 many small community banks were also prevented from electing S status because they were owned by their directors' IRAs. The American Jobs Creation Act of 2004, P.L. 108-357, addressed this problem and now allows certain IRAs (including Roth IRAs) to be shareholders of a bank S corporation. This year Treasury issued Prop. Regs. Secs. 1.1363-1(b) and (d), (9) clarifying that if a bank is an S corporation within the meaning of Sec. 1361(a)(1), its status as an S corporation does not affect the applicability of the special rules for banks under the Code. In other words, bank rules apply to banks that are S corporations.

Year end: Under Sec. 1378(a), an S corporation may use only a permitted year, which is a calendar year or any other accounting period for which the corporation establishes a business purpose to the IRS's satisfaction. In the past, several revenue procedures provided guidance on how an S corporation could elect a year end for business purposes. The IRS has issued Rev. Proc. 2006-46, (10) which provides the exclusive procedures for an S corporation to obtain automatic approval to adopt, change, or retain its annual accounting period under Sec. 442. This revenue procedure supersedes Rev. Proc. 2002-38. (11)

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). Under the facts of Letter Ruling 200709051, (12) an S corporation might have been deemed to have a second class of stock due to its distributions to its shareholders. In this ruling, the company was an LLC for the year. During the year the company filed Forms 8832 and 2553 electing to be taxed as an S corporation. The LLC agreement called for equal allocation of profits and equal distributions and liquidation rights. However, one owner received more in partnership distributions before the election. To correct the imbalance, the company distributed cash to the other owner while it was an S corporation. Even after the distribution, there was an imbalance in the LLC capital accounts. The shareholders agreed to eliminate the disparity on the books and not make any distributions for this amount. The IRS determined that the distribution made to the second owner did not terminate the S election and that, as long as the shareholders eliminated the capital account disparity without making a distribution, there would not be a termination.

In another situation, (13) an S corporation made corrective distributions to some of its shareholders so that from that point forward, every shareholder would receive a pro-rata share of all distributions. The company later discovered that the amount of some of the distributions paid to shareholders was calculated incorrectly. The S corporation planned a second round of corrective distributions, with interest on these payments. The Service said it was unclear whether these distributions would terminate the S election, but added that if a termination did occur it was inadvertent and would be disregarded.

In another letter ruling, (14) an S corporation, its shareholders, and its option holders entered into an agreement containing provisions relating to minimum shareholder distributions. Under the agreement, distributions were made based on the shareholders' various interests in the S corporation's income in the current or immediately preceding tax year; the S corporation also declared dividends and made pro-rata distributions to its shareholders based on the number of shares owned as of the record date. The IRS concluded that the S corporation's governing provisions relating to the two types of distributions did not cause it to have more than one class of stock under Sec. 1361(b)(1)(D).

In another instance, (15) a company adopted a nonqualified stock option plan with the intention that the plan not qualify under Sec. 422. The plan allowed the granting of stock options to company officers as of a given date each year; the options would expire three years later. The stock options had no readily ascertainable value at the time of issuance and were nontransferable. Under an agreement, the shares of company stock were transferable to third parties subject to certain purchase rights of the company and the nonselling shareholders. If the shares were transferred to third parties within one year of their purchase, the company had the right to purchase them at the price established in the stock option plan. The company also had the right to redeem the shares, and a shareholder had a right to sell its stock to the company on the shareholder's death, disability, termination of employment, and voluntary or involuntary transfer of the stock. The IRS concluded that the implementation of the company's stock option plan and the accompanying agreement did not cause the company to have more than one class of stock under Sec. 1361.

In another ruling, (16) an entity that elected S corporation status filed composite state income tax returns in certain states and paid the composite tax due on those returns on behalf of its eligible shareholders. The entity kept the state tax refunds with respect to the composite returns, while individual shareholders who did not participate in the composite return kept any refunds, even though some of the taxes were initially paid by the entity. These practices resulted in the entity making disproportionate distributions to certain shareholders. The entity represented that it did not intend to create a second class of stock or to terminate its S election and it made corrective distributions to the affected shareholders. The IRS concluded that the S election might have been terminated because the entity might have had more than one class of stock. However, any such termination was inadvertent; thus, the entity would be treated as continuing to be an S corporation.

QSub election: A subsidiary that wants to be treated as an S corporation must be wholly owned by a parent S corporation and a QSub election must be properly filed. The election should be filed on Form 8869, Qualified Subchapter S Subsidiary Election, by the 15th day of the third month after the effective date. In the past, numerous ruling requests involved a late filing of this election. The IRS can now waive inadvertently invalid QSub elections and terminations that occur after 2004 if the conditions of Sec. 1362 (f) are met. This is consistent with Rev. Proc. 2004-49,17 which simplifies the procedure to request relief for a late QSub election by allowing the S corporation to attach a completed Form 8869 to a timely filed tax return for the tax year the QSub was created. Despite this, there were still several requests for rulings (18) seeking relief for the late filing of a QSub election. In these, the Service determined that good cause had been shown for the delay and granted an extension of 60 days from the ruling date to make the election. In one situation, (19) the taxpayer maintained that the QSub election had been filed, but the IRS had no record of the election. The taxpayer was allowed to file another Form 8869 electing to treat the subsidiary as a QSub without penalty.

E&P Issues

If an S corporation has AE&P, it will be subject to a tax under Sec. 1375 on its excess net passive investment income if its total passive investment income exceeds 25% of its gross receipts. Most of the rulings in this area dealt with whether rental real estate activities were active or passive in nature for purposes of the tax. Under Regs. Sec. 1.13622(c)(5)(ii) (B), rents received by a corporation are treated as from an active trade or business of renting property only if, based on all the facts and circumstances, the corporation provides significant services or incurs substantial costs in the rental business. Since the issuance of the regulations, the Service has been more lenient in its definition of passive income; as a result, the number of ruling requests is down significantly. This year, (20) income from commercial and residential rentals was deemed to be active income. In these rulings, the S corporation provided various services to the tenants, including utilities and maintenance for common areas, landscaping, garbage removal, and security. In addition, the S corporation handled leasing and administrative functions, including billing, rent collection, finding new tenants, and negotiating leases. The income was nonpassive whether the investment in the rental property was directly owned by the S corporation or indirectly owned through ownership of a partnership or an LLC interest. (21)

A corporation may also have its S status terminated if it has AE&P and its passive investment income (PII) exceeds 25% of its gross receipts for more than three consecutive years under Sec. 1362(d)(3). The Service has issued rulings in which a corporation's S status terminated for this reason. In one situation, (22) an S corporation with AE&P received more than 25% of its receipts from PII for three consecutive years. On the first day of year 4, the company's S election terminated. The company contended that the termination was inadvertent and not for tax-avoidance purposes, and it agreed to make any adjustments needed to retain its S status. The IRS decided that the termination was inadvertent and allowed the company to retain its S status if, within 60 days, it filed an amended return for year 3 with an election under Kegs. Sec. 1.13681(f)(3) to make a deemed-dividend distribution of its AE&P. If a corporation makes a deemed-dividend election, it is deemed to have paid a taxable dividend to the shareholders followed by capital contributions by the shareholders. Thus the shareholders have to file amended returns to include the additional dividends in income (likely taxable at a 15% tax rate) and pay the additional taxes due. The shareholders will also reflect increases in their stock bases for the deemed capital contributions. An election to pay out the company's AE&P might be wise for many S corporations, because currently the dividends will be taxed at a maximum 15% tax rate; if the S corporation eliminates its AE&P, the PII issue goes away.

In Letter Ruling 200651024, (23) a C corporation with AE&P merged into an S corporation and the S corporation acquired the merged company's AE&P. The S corporation then sold its assets, using the installment sale method to report the resulting income; for the three succeeding years, its passive income exceeded 25% of its yearly receipts. When the taxpayer discovered that the AE&P had been recorded incorrectly and that its S election had terminated, it elected to distribute the entire AE&P under Kegs. Sec. 1.1368-1(f). The IRS ruled that the termination was inadvertent and that the taxpayer would be treated as continuing to be an S corporation.

Shareholder Eligibility

Sec. 1361(b) restricts ownership in an S corporation to U.S. citizens, resident individuals, estates, certain trusts, and certain tax-exempt organizations. In one instance, (24) a shareholder of an S corporation agreed to sell some stock to another individual. However, the individual purchased the shares through his wholly owned C corporation (an ineligible shareholder). When the problem was discovered, the shares held by the C corporation were reissued to the individual. The S corporation election terminated, but the Service ruled that the termination was inadvertent and determined that the individual would be treated as the owner of the shares while they were held by the C corporation and must report its share of the S corporation's income. The ruling did not state how the stock reissuance should be treated. As it was a wholly owned corporation, it is presumed that the shareholder would have dividend income equal to the value of the stock. In addition, under Sec. 311 (b), the S corporation would have a gain on the property distribution.

Likewise, in Letter Ruling 200704020, a corporation elected S status when it had an ineligible shareholder, an S corporation. (25) When the accountant brought this problem to the S corporation's attention, the shareholder corporation was merged into the S corporation and the stock was distributed to the other eligible shareholders. The Service found that the election was invalid but allowed the corporation S status as long as a valid election was filed. (Presumably the merger was tax free, but the IRS did not rule on that issue.)

In Letter Ruling 200705015, under a stock purchase agreement, shares of an S corporation were issued to a nonresident alien (an ineligible shareholder). (26) After the problem was discovered, steps were taken so that the corporation qualified for S status. The IRS determined that the transfer of the shares to the nonresident alien terminated the S election but that the termination was inadvertent. Inexplicably, the Service determined in a 2006 ruling that a nonresident alien in this situation would be treated as a shareholder while he held the stock and therefore would have to report his share of S income in determining his U.S. tax liability. (27) However, no mention was made in this ruling about who would be deemed the shareholder during the time the stock was held by the nonresident alien.

In an unusual situation, (28) an S corporation issued stock to a resident alien (an eligible shareholder), who was an employee of the company. The employee had an agreement that he would sell his stock back to the original owner when he terminated his employment. After he terminated his employment--but before he sold his stock--he returned to his country of birth, possibly making him a nonresident alien (i.e., he might not meet the substantial-presence test) and thus an ineligible shareholder. The Service concluded that if the shareholder became a nonresident alien it would terminate the S election, but the termination would be inadvertent.

Partnerships: A partnership is also an ineligible S corporation shareholder. In one situation, (29) shares of an S corporation were issued to a state limited partnership (LP), whose owners were individuals, and to three trusts that were eligible to make an ESBT election. The IRS ruled that the S election's termination on the issuance of the stock to the partnership was inadvertent and that the partnership's owners would be treated as owning the share of the S corporation directly from the time the stock was first transferred to the LP. The ruling was contingent on the distribution of the stock held by the LP to its partners and ESBT elections being filed within 60 days of the ruling.

In another situation, (30) a corporation made an S election. Subsequently it issued stock to a state LP. When the S corporation's tax advisers notified the company that the stock transfer terminated the S election, the LP distributed the stock to one of its owners, an individual who was an eligible shareholder. The Service found that the S election terminated but that the termination was inadvertent, and allowed the corporation to keep its S status. This situation is unique in that the stock was transferred to only one partner. The partner receiving the stock would be treated as the S shareholder from the time the stock was first transferred to the LP.

Note: This type of distribution could create a taxable transaction for the partner and the partnership if it were deemed a disproportionate distribution under Sec. 751.

In Letter Ruling 200704021, (31) an S corporation converted to a state LP that elected to be taxed as a corporation. The S corporation owners formed a new entity to act as the LP's general partner (GP). After finding out that the GP was an ineligible shareholder, the S corporation shareholders liquidated the GP and contributed the stock they received to two single-member LLCs (both eligible shareholders). Again the Service found the termination inadvertent, and the corporation was deemed an S corporation the entire time, as long as the shareholders were treated as the owners of the stock during the entire period in question.

An entity (32) that elected to be an S corporation converted to a state LP, believing that the conversion would be treated as a tax-free F reorganization. Thus, no new Form 2553 was filed. Although the entity intended that the LP be classified as an association taxable as a corporation, it inadvertently failed to file Form 8832. The entity's S election was terminated when an ineligible shareholder became the GP of the LP. The entity took two remedial actions: It named an individual as the GP, and it converted back to a state corporation. The IRS concluded that the termination of the S election by either stock acquisition by an ineligible shareholder or the potential creation of a second class of stock by conversion to a state LP was inadvertent. Thus, the IRS would continue to treat it as an S corporation.

Like a partnership, an LLC is also an ineligible shareholder. In Letter Ruling 200703027, (33) S stock was transferred to one LLC, and a second LLC purchased part of the S corporation's stock. To compound the S corporation's problems, it also had excess passive income for three consecutive years. The company had handled the transfers and the accounting internally and was unaware of the problems. When a new accountant was hired, these issues were identified. The company promptly distributed its AE&P. The IRS determined that the stock transfer to the first LLC inadvertently terminated its S election. The Service ruled that it would allow the company to retain its S status if (1) both LLCs were never treated as shareholders and their members were treated as the owners, (2) within 60 days of the ruling, the S corporation filed an amended tax return electing under Regs. Sec. 1.1368-1(f)(3) to make a deemed dividend distribution equal to its AE&P, and (3) the shareholders filed amended tax returns.

In two similar situations, (34) after a company incorporated and elected S status, all of its shareholders transferred their stock to an LLC. Only after an outside accountant was brought in was the problem identified. The Service concluded that the terminations were inadvertent but required that the LLCs not be treated as shareholders at any time. Instead, the members of the LLCs would be treated as direct owners of the stock. In these two cases and in Letter Ruling 200703027 above, the S corporation handled the stock transfers and the accounting internally.

Note: These results point out the important role of tax advisers in making sure companies do not make such mistakes.

IRAs: The general rule is that an IRA cannot be an S shareholder. In 2007 there was only one ruling in which S corporation stock was transferred to an IRA. (35) In this situation, an S shareholder transferred his stock to two IRAs. When the company discovered the problem, the shares were transferred to the beneficiaries of the IRAs. The IRS determined that the termination of the S election was inadvertent and that it would continue to be treat the corporation as an S corporation, contingent on the S corporation treating the IRA's beneficiaries as shareholders for the period the stock was held by the IRAs.

Trusts

Certain trusts are allowed to own S stock. However, there are strict rules that the trusts must follow to continue as eligible shareholders. Therefore, an S corporation and its tax advisers must constantly monitor trust shareholders' elections, trust agreements, and their subsequent modifications for compliance with S eligibility rules. This year the Service ruled in several situations on trusts as S shareholders. In the first ruling, (36) S stock was originally held by a custodian for the benefit of certain minor shareholders. The custodian thereafter transferred some of the stock to trusts, which were ineligible shareholders under Sec. 1361 (c)(2)(A). The IRS ruled that the transfer terminated the S election but that it was inadvertent, and it allowed the corporation to retain its S status as long as the shareholders agreed to make whatever adjustments were required.

In another situation, (37) an S corporation lost its S status after a trust (a permissible shareholder) ceased to qualify. An entity that was eligible to be a shareholder then purchased the trust's interest. The IRS held that the termination was inadvertent and granted relief. As a condition for granting relief, the Service directed the shareholders to include their pro-rata shares of S corporation income and to make any necessary basis adjustments.

After another corporation (38) elected S status, its stock was transferred to three trusts, all of which were eligible shareholders. However, one trust then transferred its stock to a charitable remainder unitrust (CRUT), which was an ineligible shareholder. Later another of the three original shareholders transferred some of its shares to the CRUT. When the terminating events came to light, the CRUT transferred all of its shares back to the original shareholders. The IRS concluded that the termination was inadvertent and ruled that the taxpayer would be treated as an S corporation throughout the period, if the trusts that had transferred stock to the CRUT were treated as if they had continued to own the stock for the entire period and as if the trusts' income tax liabilities were calculated on that basis.

Note: Presumably, the trusts would have to file amended returns to eliminate the charitable contribution deduction they took for their contribution of the stock to the CRUT.

In a fourth ruling, (39) the taxpayer elected S status on formation. A trust that was entirely owned by one individual was a shareholder. When the owner died, the trust, while ceasing to qualify as a grantor trust, remained a permissible S shareholder for two years under Sec. 1361(c)(2)(A)(iii). Other trust assets were distributed to a nonmarital trust, but the S stock became part of a marital trust for the owner's surviving spouse, who had power to withdraw all assets therein. The IRS ruled that the S election did not terminate on the owner's death and that the trust was a permissible S shareholder from the date of death until the day before the nonmarital trust was fully funded. The Service specifically noted that the power granted to the spouse to withdraw all assets (including the stock) resulted in the spouse's being treated as the owner of the entire trust from the date on which the marital portion of the trust was ascertainable.

The IRS also ruled (40) that a corporation's S election was not terminated when a shareholder tried to transfer his shares to a trust but the transfer was declared void ab initio by court order. The Service determined that the trust was never a shareholder; therefore, the corporation's election was never affected.

Testamentary Trusts 

In a recent ruling, (41) stock held in a revocable trust was transferred to a trust that was set up on the death of an S shareholder. The trust qualified as a QSST, but the beneficiary failed to file the QSST election. The Service held that the failure to make the QSST election terminated the company's S election but that the termination was inadvertent, and it allowed the company to retain its S status as long as the beneficiary filed a valid QSST election within 60 days of the rulings and amended returns. Similar situations can be found in Letter Rulings 200718011 and 200704027. (42)

In another instance, (43) an S corporation transferred stock to a grantor trust that was an eligible shareholder. Under the terms of the trust, on the death of the grantor the assets were to be transferred to two recipient trusts that qualified as QSSTs. However, the trust did not distribute the S stock until more than two years after the grantor died; thus, the trust ceased to be an eligible shareholder. In addition, the beneficiaries of the recipient trusts failed to file QSST elections. The IRS determined that the S election was terminated when the trust became an ineligible shareholder but that the termination was inadvertent. Consequently, the IRS ruled that it would continue to treat the entity as an S corporation, contingent on the recipient trusts making QSST elections within 60 days of the ruling.

Other Trust Issues

Election requirements: Another problem encountered by trusts 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. Often this election is filed incorrectly or not timely filed, and an inadvertent termination ruling is needed. This year, there were numerous instances (44) in which a trust was intended to be treated as either a QSST or an ESBT and 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 a 60-day extension from the ruling date to make the election. In each of these cases, the ruling was contingent on the corporation's being treated as an S corporation from the time the trust received the stock until the present. Therefore, all shareholders had to include their pro-rata share of the corporation's income, make any needed adjustments to basis, and take into account any distributions made by the S corporation. If necessary, amended tax returns for the corporation and its shareholders were required to be filed.

In a slightly different situation, (45) an S corporation learned only after electing such status that its shareholders, two trusts, had not filed QSST elections. Such elections, signed by the trust beneficiaries' parents, were then filed. Only afterward did the taxpayer learn that two of the beneficiaries were not minors at the time their parents signed for them. Moreover, the trusts had failed to distribute all trust income to the beneficiaries (as required by Sec. 1361(d) (3)(B)). The taxpayer sought relief from all of the errors, which the IRS granted. In this instance the IRS pointed out that inadvertence was shown by the fact that the taxpayer had no control over these events and that they were not part of a plan to terminate the election.

In another situation, (46) shares in an S corporation were transferred to two trusts, each of which were permitted shareholders. Thereafter, the beneficiaries of each trust elected to treat the trusts as QSSTs. Though each trust was intended to qualify as a QSST, the trustees failed to comply with the income distribution requirements. When the problem was discovered, the trust distributed the income and the beneficiaries agreed to file amended tax returns. The IRS held that the termination was inadvertent and that the taxpayer's S status would continue.

In one ruling, (47) before an entity elected to be treated as an S corporation, a trust and an LLC owned shares of the entity, and the trust owned an interest in the LLC. The LLC distributed its shares in the entity to the trust so that the entity would be eligible to make the S election. The trust was initially eligible to be an ESBT, and its trustee made a proper election. The trust instrument provided that on the trust's termination, its interest in the LLC would be distributed to or for the benefit of the grantor's descendants and not to the LLC. The S corporation's shareholder agreement provided that the transfer of any of its stock to any corporation, partnership, LLC, or other entity was prohibited. The IRS concluded that the LLC was not a beneficiary of the ESBT because of the provision in the trust's governing instrument on the distribution of trust property to the LLC. Thus, the trust was an eligible shareholder.

Trust modifications: The Service also ruled (48) on how a modification of a trust would affect its ESBT status. A trust settled by a decedent was originally funded with corporate stock. When its issuer became an S corporation, each subtrust chose to be an ESBT. Modifications were proposed by the trustee to be in compliance with new state laws governing the administration of trusts. The Service determined that the modification would not alter or otherwise affect the trusts' ESBT status because it did not result in a change in the beneficiaries of the trusts.

Terminations

Under Sec. 1362(g), if an S corporation's election is terminated, it is not eligible to reelect S status for five tax years. S and C short years are treated as two separate tax years. In one instance, (49) a corporation had revoked its S election. All of the stock was then sold to an unrelated individual who wanted to elect S status. Even though five years had not elapsed, the Service concluded that the entity met its burden of establishing just cause and allowed the corporation to reelect S status because there had been a morethan-50% change in ownership.

Conclusion

The second part of this article, in the November 2007 issue, will examine recent S corporation operational tax issues.

Editor's note: Dr. Burton is a member of the AICPA Tax Division's S Corporation Taxation Technical Resource Panel (TRP). Dr. Karlinsky is a member of the AICPA Tax Division's C Corporation Taxation TRP.

For more information about this article, contact Dr. Burton at [e-mail] or Dr. Karlinsky at [e-mail].

Hughlene Burton, Ph.D., CPA 

Associate Professor

Department 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

(1) Rev. Proc. 2003-43, 2003-1 CB 998.

(2) See, e.g., IRS Letter Rulings 200711018 (3/16/07), 200705003 (2/2/07), and 200649006 (12/8/06).

(3) See, e.g., IRS Letter Rulings 200718015 (5/4/07), 200712014 (3/23/07), and 200649009 (12/8/06).

(4) IRS Letter Ruling 200712025 (3/23/07).

(5) See, e.g., IRS Letter Rulings 200712024 (3/23/07), 200701022 (1/5/07), 200652016 (12/29/06), 200648008 (12/1/06), and 200647027 (11/24/06).

(6) IRS Letter Ruling 200713022 (3/30/07).

(7) IRS Letter Ruling 200722001 (6/1/07).

(8) IRS Letter Ruling 200702027 (1/12/07).

(9) REG-158677-05, 71 Fed. Reg. 50007 (8/24/06).

(10) Rev. Proc. 2006-46, 2006-45 IRB 859.

(11) Rev. Proc. 2002-38, 2002-1 CB 1037.

(12) IRS Letter Ruling 200709051 (3/2/07).

(13) IRS Letter Ruling 200722011 (6/1/07),

(14) IRS Letter Ruling 200709004 (3/2/07).

(15) IRS Letter Ruling 200708018 (2/23/07).

(16) IRS Letter Ruling 200705004 (2/2/07).

(17) Rev. Proc. 2004-49, 2004-2 CB 210.

(18) IRS Letter Rulings 200720018 (5/18/07), 200705023 (2/2/07), 200704012 (1/26/07), and 200649015 (12/8/06).

(19) IRS Letter Ruling 200705024 (2/2/07).

(20) IRS Letter Rulings 200713017 (3/30/07), 200705006 and 200705007 (2/2/07), 200704008 (1/26/07), and 200647026 (11/24/06).

(21) IRS Letter Rulings 200704016 (1/26/07) and 200651010 (12/22/06).

(22) IRS Letter Ruling 200709017 (3/2/07).

(23) IRS Letter Ruling 200651024 (12/22/06).

(24) IRS Letter Ruling 200721002 (5/25/07).

(25) IRS Letter Ruling 200704020 (1/26/07).

(26) IRS Letter Ruling 200705015 (2/2/07).

(27) IRS Letter Ruling 200621009 (5/26/06).

(28) IRS Letter Ruling 200649008 (12/18/06).

(29) IRS Letter Ruling 200652012 (12/29/06).

(30) IRS Letter Ruling 200712016 (3/23/07).

(31) IRS Letter Ruling 200704021 (1/26/07).

(32) IRS Letter Ruling 200649005 (12/8/06).

(33) IRS Letter Ruling 200703027 (1/19/07).

(34) IRS Letter Rulings 200703028 (1/19/07) and 200652035 (12/29/06).

(35) IRS Letter Puling 200718020 (5/4/07).

(36) IRS Letter Puling 200651017 (12/22/06).

(37) IRS Letter Ruling 200651027 (12/22/06).

(38) IRS Letter Ruling 200703023 (1/19/07).

(39) IRS Letter Ruling 200652006 (12/29/06).

(40) IRS Letter Ruling 200722022 (6/1/07).

(41) IRS Letter Ruling 200652001 (12/29/06).

(42) IRS Letter Rulings 200718011 (5/4/07) and 200704027 (1/26/07).

(43) IRS Letter Ruling 200647004 (11/24/06).

(44) See, e.g., IRS Letter Rulings 200716011 (4/20/07), 200705012 (2/2/07), 200701021 (1/5/07), 200652030 (12/29/06), and 200651008 (12/22/06).

(45) IRS Letter Ruling 200703032 (1/19/07).

(46) IRS Letter Ruling 200638019 (9/22/06).

(47) IRS Letter Ruling 200702024 (1/12/07).

(48) IRS Letter Ruling 200652040 (12/29/06).

(49) IRS Letter Ruling 200709047 (3/2/07).