Current developments.

This two-part update 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.

From a tax perspective, the time period covered in this update--July 16, 1998 to July 1, 1999--continued to focus 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, many letter rulings reflected the 1996 legislative changes; most significantly, Rev. Proc. 98-55(1) extended the automatic election relief of Rev. Proc. 97-40(2) from six months to a year, waived the letter ruling fee for certain late S elections and permitted the correction of some errors in electing qualified subchapter S subsidiary (QSub), qualified subchapter S trust (QSST) and electing small business trust (ESBT) status.

As will be discussed in Part II of this article, in the November 1999 issue, S operational issues continued to be addressed by the courts and Treasury, including five cases on cancellation of debt income and its effect on an S shareholder's basis for loss; a final regulation on employee stock ownership plans (ESOPs) that own S stock; a consolidated return proposed regulation on the need for two returns (rather than three) when an S corporation is acquired by a consolidated group; and proposed regulations under Secs. 1366-1368. In addition, Notice 99-6(3) advised taxpayers how to handle a disregarded entity's (i.e., a QSub's) payroll taxes. Recent letter rulings highlighted Secs. 1033 and 1031 liability isolation techniques using disregarded entities. Two Tax Court cases(4) created significant opportunities to avoid the repeal of the General Utilities doctrine and to reduce the tax cost of closely held stock transfers.

Statistics reveal the C, S and partnership audit rates.(5) Of the total S returns filed in 1995 and 1996, .92% and 1.04% were audited, respectively. This contrasts with C returns, for which the audit rate was between 2.76% and 14.08% for 1995 and between 3.52% and 16.02% for 1996, depending on asset size. The partnership audit rate was up slightly, to 0.49% and 0.59% respectively, lower than the S audit rate.

The IRS also announced(6) a significant break for small businesses. Fees for letter rulings increased for large companies to $5,000 from $3,650; the fee was reduced to $500 for small businesses with gross incomes of less than $1 million, effective Jan. 11, 1999. This reduction will affect many S corporations and should encourage small businesses to seek assistance when faced with complex tax issues.

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 retain its S status continuously. The IRS, at the urging of Congress, has been reasonable in granting inadvertent termination relief.

Prior to the SBJPA, the IRS had no authority to allow late S elections. Sec. 1362(b)(5) now gives the IRS the power to correct inadvertent errors in electing S status if the taxpayer shows that it made the mistake inadvertently, qualified to be an S corporation and reported as if it were an S corporation. A plethora of inadvertent election rulings were issued in the period covered, despite recent procedures issued to ameliorate the problem.

While some commentators had predicted that S status would not be the future entity of choice because of the expected popularity of limited liability companies (LLCs), hundreds of ruling requests have involved new businesses making procedural errors in electing S status.

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 United Parcel Service).

In Letter Ruling 9904011,(7) the IRS granted S status from date of incorporation, even though it did not receive Form 2553 and there was no proof of mailing. However, in Fankhauser,(8) under similar facts, the election was disallowed. The taxpayer maintained that the election was mailed with the corporation's Form SS-4, Application for Employer Identification Number; the Service had no record of receiving the S election. The Tax Court denied the election, because the form had not been mailed either registered or certified mail, the taxpayer had no mailing record and the Sixth Circuit (to which an appeal would lie) strictly adhered to the Sec. 7502(c) requirements. The letter ruling route often generates a more favorable result than the courts on such facts.

Late Elections

Continuing the trend, Rev. Proc. 98-55 extended Rev. Proc. 97-40 to allow late S elections without obtaining a letter ruling (and expending the user fee). The time to file a late election was extended from six to 12 months. (Rev. Proc. 97-48(9) had specified only two situations granting automatic relief for a late S election.)

The procedure applies only to a corporation (1) that did not timely file an S election under Sec. 1362(a)(1), (2) for which an S election was filed within 12 months of the election's original due date and (3) for which the unextended due date of the return (excluding extensions) for the first year the corporation intended to be an S corporation has not passed.

To be granted relief under the procedure, a taxpayer must file a valid Form 2553 with the required signatures and the statement "FILED PURSUANT TO REV. PROC. 98-55" at the top of the form. A statement must be attached explaining the reason for the failure to timely file the S election. Rev. Proc. 98-55 also grants an extension of time to file late ESBT, QSST and QSub elections (discussed below).

Who Signs Form 2553?

A question sometimes arises as to who must sign Form 2553. Under Sec. 1362(a)(2), all shareholders who own stock on the date the election is made must sign it. If the election is to be retroactive to the beginning of the year, Sec. 1362(b)(2) (B) requires the signatures of all shareholders who owned stock that year (prior to the election). In Letter Ruling 9909010,(10) all shareholders existing at the date of the resolution to elect S status consented to the election. Between that date and when Form 2553 filed, new shareholders acquired stock, but did not sign Form 2553; the corporation believed that only shareholders at the time of the election decision had to consent. The IRS ruled that the omission of the new shareholders' signatures invalidated the election, but that the omission was inadvertent; thus, the corporation would be treated as an S corporation from the effective date of the Form 2553.

If an election is made under Rev. Proc. 98-55, the corporation should ensure that all affected shareholders sign Form 2553. Given that the election may be made much later than two and one-half months after the beginning of the year, many more signatures may be required. If some shareholders are residents of community property states, their spouses should also sign the election.

Another issue is who must sign Form 2553 for a trust. In Letter Ruling 9917058,(11) an individual signed both Form 2553 and the QSST election as the trustee. The IRS ruled that the individual should have signed the elections on behalf of the beneficiary as legal representative. The election with the signature as trustee was invalid; however, as the error was inadvertent, the corporation was granted S status and the trust was granted QSST status from inception.

Inadvertent Election Issues

The IRS issued hundreds of similar rulings(12) during this period allowing S status from each company's inception under Sec. 1362(b)(5). A number of rulings(13)involved a lapse in communication between the attorney and the accountant regarding a new enterprise, such that Form 2553 was never filed; relief was granted. In three other cases,(14) Form SS-4, Application for Employer Identification Number, had been filed, indicating the corporation was an S corporation; Form 1120S, U.S. Income Tax Return for an S Corporation, was also filed. However, Form 2553 was never filed. The IRS granted S status from inception. In Letter Ruling 9904030,(15) the election was not filed because the owner was preoccupied handling new business. The IRS allowed S status, effective as of the date of incorporation.

In other rulings,(16) an owner, lawyer, accountant or financial consultant forgot to mail or complete Form 2553, but the company filed Form 1120S and the shareholders included the income on their individual returns. The IRS allowed S status from the company's inception. In Letter Ruling 9852003,(17) a CPA timely prepared Form 2553; although the owner signed it and gave it to the bookkeeper to send out "as soon as possible," the bookkeeper filed it untimely. S status was permitted from inception of the entity.

However, in Letter Ruling 9920006,(18) the taxpayer was granted S status for its second year. The entity intended to be an S corporation since inception and acted as such. On discovering that its S election had not been timely filed, the corporation asked to be treated as an S corporation for its second tax year, which the IRS granted. Requesting S status for the second year may trigger significant problems, including the Sec. 1374 built-in gains tax (if there are earnings and profits (E&P) in the first year), accumulated adjustments account tracking, potential passive investment income (PII) tax under Sec. 1375 and Sec. 1363(d) LIFO recapture. The taxpayer might have been better off requesting S status from inception, avoiding S-level taxes.

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 9918050,(19) a C corporation acquired an S corporation in a taxable transaction for the S shareholders. The companies made a Sec. 338(h)(10) election. Under the terms of the sale, the S shareholders were to be compensated for their individual Federal and state income tax costs, which would vary by individual. The IRS treated this transaction as a sale of stock by the shareholders, not a liquidating distribution. Thus, the S corporation was not considered to have a second class of stock, because a contractual obligation (not a governing provision) created the potential inequity among the shareholders.

When S corporations create employment or consulting agreements, profit-sharing pools and other fringe benefits for employees or owners, there has been some concern that this may create a second class of stock. In Letter Ruling 9839007,(20) key employees received S stock from a stock incentive plan. The company had a call option to repurchase the stock under certain circumstances. The corporation wanted to enter into an agreement with the employee-stockholders to pay them the excess (if any) of the highest of the last three years' appraised values for the stock over the call price if the option was exercised. The IRS ruled that this agreement would not be treated as a second class of stock under Sec. 1361(b)(1)(D) and would be disregarded in determining whether the S stock conferred identical rights.

Letter Ruling 9840035(21) addressed the possibility of a second class of S stock in a corporation that proposed to create incentive stock option and shared appreciation rights plans, under which employees could receive cash, stock or property equivalent to the stock appreciation. The IRS concluded that the plan rights would not be treated as a second class of stock; thus, S status would not terminate.

In the context of an ESOP shareholder, Letter Ruling 9906044(22) addressed a second class of stock concern when the participants could choose whether to receive dividends. The IRS ruled that the ESOP (not the participants) was the S shareholder; thus, the ESOP distribution rules would not create a second class of stock, because all shares had the same rights to distribution and liquidation proceeds. Basically, the IRS ruled that the distribution provision did not change the ESOP's rights.

Pre-SBJPA Rulings

Prior to the SBJPA, a myriad of rulings addressed the inadvertent termination of S status when a corporation acquired 80% or more of a domestic or foreign corporation. After the modification of Sec. 1361(b)(2) (to allow affiliated groups) and the addition of Sec. 1361(b)(3) (to allow QSubs), only a few current rulings address such inadvertent terminations; they are discussed in case the reader has historical or IRS audit problems in the area of ineligible affiliated groups. In each ruling, the IRS allowed inadvertent termination relief, even though the SBJPA changes were not retroactive.

In Letter Ruling 9917013,(23) one S corporation acquired another in 1995; the acquisition terminated both S elections. When the error was detected, the companies made the necessary changes in stock ownership. The IRS ruled that the terminations were inadvertent, allowing both companies to retain S status; presumably, the subsidiary would be classified as a QSub.

In Letter Ruling 9922016,(24) an S corporation acquired 80% of a C corporation, thinking it was sanctioned under the SBJPA; however, the acquisition occurred before the effective date. The IRS ruled that the S election was inadvertently terminated and allowed the corporation to retain S status.

In Letter Ruling 9851025,(25) a C corporation wholly owned a domestic international sales corporation (DISC). (A DISC cannot be an S corporation or a QSub.) The parent elected S status on its accountants' advice that it could do so and continue to wholly own the DISC. New advisers later notified the parent that the S election was invalid, because an S corporation could not own more than 80% of the stock of another corporation. The parent then transferred 21% of the DISC stock into a trust owned by the parent's sole shareholder and made a second S election, to be effective for its second year. The IRS ruled that the first election was ineffective, but that the corporation would be an S corporation from the second election. Because the parent was formerly a C corporation, all of the corporate-level taxes could apply (e.g., Secs. 1374, 1375 and 1363(d)). Also, the distribution of the stock to a grantor trust would be a taxable event to both the distributing corporation (under Sec. 311) and to the shareholder (under Sec. 301).

QSubs

There has been a dramatic decrease in affiliated group letter rulings after the modification of Sec. 1361(b)(2) (to allow affiliated groups) and the addition of Sec. 1361(b)(3) (to allow QSubs). In their place are a variety of QSub late election rulings. Hopefully, the issuance of Rev. Proc. 98-55 will lead to a decrease in QSub letter rulings and filing fees.

Making the Election

The SBJPA did not set out filing requirements for electing QSub status, but Notice 97-4(26) offered guidance. The notice covered new companies, existing 100% subsidiaries and newly acquired companies. A QSub election is made on Form 966, Corporate Dissolution or Liquidation. In effect, the subsidiary is liquidated under the tax-deferral provisions of Secs. 332 and 337; these provisions do not apply if the QSub is insolvent (i.e., having liabilities exceeding the fair market value (FMV) of assets).

Proposed regulations(27) later modified Notice 97-4, and will both greatly explain and complicate the QSub election and termination rules when made final. The preamble states that Notice 97-4 is to be followed until then. The proposed regulations envision that, before then, the IRS will create a QSub election form to use instead of Form 966.

Prop. Regs. Sec. 1.1361-3(a)(3) presents 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, which may be as early as two months and 15 days before (or 12 months after) the actual filing.

Prop. 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 employer 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.

Prop. Regs. Sec. 1.1361-4(a)(2) provides that the step-transaction doctrine applies to QSubs, but its application would be delayed until 60 days after the regulations are finalized.(28)

Late filing: Most of the covered period's rulings involved the late filing of a QSub election. For example, in Letter Ruling 9917021,(29) an S corporation formed a subsidiary for which it desired QSub status. The company's attorney did not advise the corporation that an election was needed. The IRS granted a 60-day extension from the time of the ruling to make the election. In Letter Ruling 9839012,(30) an S corporation thought it needed to file only Form 2553 to make a QSub election. The IRS found the omission to be inadvertent and granted an extension to make a QSub election.

In Letter Ruling 9919017,(31) an S corporation acquired more than 80% (but less than 100%) of the stock of another S corporation, which terminated both S elections. As soon as the corporation was informed of its error, it purchased the rest of the stock and made a QSub election. The IRS ruled that the termination was inadvertent, allowed the corporation to retain its S status and allowed the QSub election.

The IRS issued Rev. Proc. 98-55 to reduce the number of letter rulings in this area. Under the procedure, a corporation may be granted additional time to file a QSub election if the subsidiary fails to qualify as a QSub solely because (1) the parent failed to file a timely election, (2) the unextended due date of the S corporation's tax return has not passed and (3) the S corporation has reasonable cause for its failure to timely file the QSub election. The election must be made within 12 months of the due date for filing a QSub election and must state at the top of the form "FILED PURSUANT TO REV. PROC. 98-55." Attached to the election must be a statement explaining the reason for the failure to file a QSub election within the required time period. After receiving the application, the IRS will notify the corporation of the result.

E&P Issues

If an S corporation has accumulated C E&P (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 it has excess PII (i.e., more than 25% of gross receipts) for three consecutive years, its 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).

In Letter Ruling 9923007,(32) a C corporation wanted to elect S status; its primary assets were rental property, cash and investments. To diversify and increase liquidity, the corporation planned to invest in a publicly traded partnership (PTP) taxed as a partnership. The company requested a ruling as to the treatment of the PTP's gross receipts after an S election. The IRS ruled that the corporation's distributive share of the PTP's gross receipts would be included in its gross receipts for PII purposes, but PTP gross receipts from specific, enumerated activities would not be PII for Sec. 1375 purposes.

In Letter Ruling 9917070,(33) an S corporation was trying to reach a liquidation agreement with all its shareholders. During this period, the corporation had AE&P and received more than 25% of its gross receipts from PII for three consecutive years. The IRS ruled that while the S election had terminated, it was inadvertent; if the corporation met certain conditions, it could keep its S status until liquidation.

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 be performed or significant costs be incurred to elevate the activity to nonpassive. In a series of rulings,(34) rentals from warehouses, industrial buildings, apartment complexes and commercial real estate property were all deemed to be active. In Letter Ruling 9917029,(35) although the owner of commercial real estate outsourced a significant number of functions, the rents were still viewed as active income.

In Letter Ruling 9906002,(36) an S corporation with AE&P received net lease income from passive rental activities that exceeded 25% of its gross receipts for three consecutive years. Technically, the company's S election terminated on the first day of the fourth year. When an accountant discovered the error, the company distributed a dividend to its shareholders to eliminate AE&P. The IRS ruled the termination inadvertent, allowing the corporation to retain S status.

In Letter Ruling 9921022,(37) two related C corporations with AE&P wanted to merge tax-free and convert the survivor to S status, but were concerned about the character of their real estate rental income. One company provided management and financing activities; the other provided operating activities. The rental income was determined to be active, because the corporations provided significant services in connection with the real estate leases.

All of the above PII rulings dealt with the rental of real property. In Letter Ruling 9851041,(38) a corporation leased equipment and provided marketing, collection and lease preparation services. Although the corporation did not provide any services directly to the lessee, the IRS determined that the rental income was active, due to the substantial cost the corporation incurred in securing and maintaining the leases.

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 Letter Ruling 9831027,(39)) S stock was transferred to a C corporation (an ineligible shareholder). When the error was discovered, the C corporation distributed the S stock to its owner, a U.S. resident individual (in a transaction subject to Secs. 311 and 301 income recognition). The IRS ruled the termination inadvertent and allowed the corporation to retain S status.

Letter Ruling 9924018(40) addressed loss of S status when a resident alien shareholder moved overseas and abandoned his permanent resident status. Because a nonresident alien owned S stock, S status terminated; however, the IRS granted inadvertent termination relief.

Other ineligible shareholders include partnerships, LLCs, certain trusts and individual retirement accounts (IRAs). In Letter Ruling 9909023,(41) an S corporation issued shares to a limited partnership; the latter's tax adviser notified the company that a limited partnership could not be an S shareholder. The shares were then distributed to the owners of the limited partnership. The IRS ruled that the termination was inadvertent; the owners of the limited partnership were to be treated as the owners of the S stock.

In Letter Ruling 9907009,(42) a trust created by a will held S stock for more than two years. After that period elapsed, the trust filed an ESBT election. The IRS ruled that the Sec. 1361 (c)(2)(A)(iii) termination that occurred at the two-year mark was inadvertent, allowing the trust to be an ESBT from that point on.

In Letter Ruling 9909026,(43) 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.

Trusts

An S corporation and its tax advisers must carefully monitor its trust shareholders. During the period covered, a variety of inadvertent termination letter rulings addressed trust issues. In Letter Ruling 9909012,(44) a law firm determined that some trusts that owned S stock were ineligible to be QSSTs. The trusts were amended to qualify and more QSST elections were filed. The IRS ruled the termination inadvertent and allowed the trusts to file corrected elections as ESBTs.

QSSTs and ESBTs require a separate election to be made for the trust to qualify as an S shareholder. Many times the election is filed incorrectly, resulting in the need for an inadvertent termination ruling. For example, in Letter Ruling 9907012,(45) an S corporation transferred stock to a QSST, but no QSST election had been made. When this oversight was detected, an election was filed. The lack of a QSST election technically terminated the S election, because the trust was an ineligible shareholder. The IRS ruled the termination inadvertent; however, the trust could be a shareholder (but not a QSST) until the election was filed. In Letter Ruling 9921009,(46) S stock options were transferred to trusts intended to be ESBTs, but the trustee failed to make timely elections. The IRS allowed inadvertent termination relief, permitting ESBT elections to be filed.

Trust elections: Because there are numerous problems each year with the filing of trust elections, Rev. Proc. 98-55 now allows an extension to file either a QSST or an ESBT election when the corporation has an otherwise valid S election. The procedure grants automatic relief under Sec. 1362(f) if (1) the S election terminated solely because a QSST beneficiary or ESBT trustee failed to file a timely election; (2) all taxpayers whose tax liability and returns would be affected by the election have reported their income consistent with the corporation's S election; (3) the failure to file a timely QSST or ESBT election was inadvertent; and (4) within 24 months of the election's original due date, the QSST beneficiary or ESBT trustee files a proper election with the appropriate service center. The election must state at the top "FILED PURSUANT TO REV. PROC. 9855." If the procedure's requirements are met, the corporation will be treated as an S corporation continuously. In addition, during the period between when the election should have been made and when it was actually filed, the trusts will be treated as described in Sec. 1361 (c)(2)(A); the rules applicable to QSSTs and ESBTs will apply.

ESOPs

The SBJPA permitted an ESOP to own S stock, beginning in 1998. Sec. 409(h) generally requires ESOPs to allow participants the right to take plan distributions in the form of employer securities. This provision can create a potential problem for S corporations, because they cannot have more than 75 shareholders. The Taxpayer Relief Act of 1997 (TRA '97) created an exception to the stock distribution requirement for ESOPs maintained by S corporations; S ESOPs are not required to offer distributions of employer securities.(47)

S ESOPs that changed their distribution options may be in violation of the Sec. 411(d)(6) anti-cutback provision, which protects plan participants from having their benefits reduced because of plan changes. To rectify the problem, Treasury finalized Regs. Sec. 1.411(d)-4, which allows S corporations to retroactively amend ESOPs to eliminate the stock distribution option without violating the anti-cutback rule.(48) Regs. Sec:. 1.411(d)-4, Q&A-2, allows the plan to be. amended to eliminate the stock distribution option for benefits accrued as of the amendment's effective date. The amendment can be adopted any time before the end of the remedial amendment period for TRA '97 changes; most plans have until the end of 1999 to make amendments.

Revocations and Terminations

Assuming that the revocation or termination of an 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 also be subject to Secs. 1374 and 1375 S-level taxes. Under Regs. Sec. 1.1362-5, the IRS issued Letter Ruling 9918031,(49) which permitted re-election of S status before five years; between the time the S election was revoked and the new election, 77% of the stock had changed hands.

Similarly, in Letter Ruling 9904008,(50) a disgruntled shareholder transferred S stock to an LLC, terminating S status. Because the terminating event was not within the corporation's reasonable control, the IRS permitted re-election before five years.

In FSA 1998-326,(51) the Service ruled that an affiliated group member that had disaffiliated could re-elect S status, regardless of the reason for the restructuring. In this case, the only reason to restructure was to convert to S status. This ruling appears to be contrary to those in other areas (e.g., Sec. 355) that require a nontax business purpose.

In Bakersfield Westar, Inc.,(52) a bankruptcy trustee argued that the revocation of an S election was a transfer of property that could be disregarded. Both the S corporation and its shareholder ran into financial difficulty. On advice from his tax adviser, the shareholder revoked the S election; two weeks later, he declared bankruptcy personally and for the corporation. The bankruptcy trustee argued that the revocation of the S election deprived the corporation, as it then became taxable on its income. Because the company had always been an S corporation, there were no corporate attributes to offset the income. The Bankruptcy Court held that the revocation was not a transfer of property; the Ninth Circuit reversed, holding that the right to revoke an S election has value to the corporation and, therefore, must be characterized as property. The court also determined that bankruptcy provisions can override specific Code provisions.

QSubs

If a QSub election is revoked, such status cannot be re-elected for five years without IRS consent. However, under Prop. Regs. Sec. 1.1361-5(d)(1), if a QSub election is revoked or otherwise terminated, but the corporation was never a C corporation after the revocation, an S election within five years is permissible without IRS consent.

In Letter Ruling 9823016,(53) the Service permitted a second S election within five years. In a corporate division, a parent elected QSub status for its wholly owned subsidiary, then spun off the QSub to its shareholders, who elected S status for the subsidiary. The same result occurred in Letter Ruling 9909011,(54) in which an S corporation sold its QSub to an unrelated S corporation; the sale terminated the QSub election. The five-year rule was waived; the new S parent was allowed to make a QSub election for the subsidiary.

If the QSub election is revoked, Sec. 351 would apply to the deemed formation. The tax adviser should be aware that, if Sec. 357(c) applies (i.e., if liabilities exceed the adjusted basis of the assets transferred), gain will be recognized to the extent of the excess. If the parent S corporation's deemed transfer is subject to Sec. 357(c), an interesting planning tool would be to contribute a self-written corporate note to the new entity. Under Peracchi,(55) this would seem to create basis for Sec. 357(c) purposes.

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 1999 issue, will explore S operational issues.

Abbreviations Commonly Used in The Tax Adviser

TTA             The Tax Adviser
aff'g           affirming
AFTR2d          American Federal Tax Reports, second series (RIA)
Ann.            IRS Announcement
CB              Cumulative Bulletin
Cir.            Court of Appeals
Cl. Ct.         Claims Court
COBRA           Consolidated Omnibus Budget Reconciliation Act of
                 1985
Ct. Fed. Cls.   Court of Federal Claims
DC              District Court
ERISA           Employee Retirement Income Security Act of 1974
Fed. Cir.       Court of Appeals for the Federal Circuit
Fed. Reg.       Federal Register
F2d             Federal Reports, second series
F3d             Federal Reports, third series
F Supp          Federal Supplement
GCM             General Counsel Memorandum
HIPAA           Health Insurance Portability and Accountability Act
                 of 1996
H. Rep.         House Ways and Means Committee Report
IR              Internal Revenue News Release
IRB             Internal Revenue Bulletin
IRSRRA '98      Internal Revenue Service Restructuring and Reform
                 Act of 1998
Regs. Sec.      Treasury Regulation
Rev. Proc.      Revenue Procedure
Rev. Rul.       Revenue Ruling
rev'g           reversing
RRA             Revenue Reconciliation Act of 1993
SBJPA           Small Business Job Protection Act of 1996
Sec.            Section (refers to the Internal Revenue Code of
                 1986, unless otherwise indicated)
S. Rep.         Senate Finance Committee Report
Sup. Ct.        Supreme Court
TAM             Technical Advice Memorandum
TBOR2           Taxpayer Bill of Rights 2
TC              Tax Court (regular decision)
TC Memo         Tax Court (memorandum decision)
TD              Treasury Decision
TRA '86         Tax Reform Act of 1986
TRA '97         Taxpayer Relief Act of 1997
USTC            United States Tax Cases (Commerce Clearing House)

Editor's note: Dr. Karlinsky is a member of the AICPA Tax Division's Corporations & Shareholders Taxation Committee.

(1) Rev. Proc. 98-55, IRB 1998-46, 27.

(2) Rev. Proc. 97-40, IRB 1997-33, 50.

(3) Notice 99-6, IRB 1999-3, 12.

(4) Martin Ice Cream Co., 110 TC 189 (1998); William Norwalk, TC Memo 1998-279.

(5) See 1997 IRS Data Book (July 1998).

(6) IR-1999-04 (1/11/99).

(7) IRS Letter Ruling 9904011 (10/27/98).

(8) Emil Fankhauser, TC Memo 1998-328.

(9) Rev. Proc. 97-48, IRB 1997-43, 19.

(10) IRS Letter Ruling 9909010 (11/23/98).

(11) IRS Letter Ruling 9917058 (2/3/99).

(12) See, e.g., IRS Letter Rulings 9837012 (6/11/98), 9904003 (10/23/98), 9905006 (10/29/98), 9906009 (11/14/98) and 9909036 (12/7/98).

(13) See, e.g., IRS Letter Ruling 9851034 (9/15/98).

(14) IRS Letter Rulings 9852008 (9/23/98), 9909019 (11/30/98) and 9909057 (12/4/98).

(15) IRS Letter Ruling 990403(/ (11/31/98).

(16) See, e.g., IRS Letter Rulings 9837010 (6/10/98) and 9918037 (2/5/99).

(17) IRS Letter Ruling 9852003 (9/15/98).

(18) IRS Letter Ruling 9920006 (2/8/99).

(19) IRS Letter Ruling 9918050 (2/9/99).

(20) IRS Letter Ruling 9839007 (6/23/98).

(21) IRS Letter Ruling 9840035 (7/2/98).

(22) IRS Letter Ruling 9906044 (11/3/98).

(23) IRS Letter Ruling 9917013 (1/14/99).

(24) IRS Letter Ruling 9922016 (2/23/99).

(25) IRS Letter Ruling 9851025 (9/14/98).

(26) Notice 97-4, 1997-1 CB 351.

(27) REG-251698-96 (4/22/98); for a discussion, see Lindholm and Karlinsky, "The Benefits and Burdens of QSubs," 30 The Tax Adviser 490 (July 1999).

(28) See id., page 492.

(29) IRS Letter Ruling 9917021 (1/22/99).

(30) IRS Letter Ruling 98391)12 (6/24/98); see IRS Letter Rulings 9851027 (9/14/98), 9907010 (11/16/98) and 9909053 (12/3/98).

(31) IRS Letter Ruling 9919017 (2/9/99).

(32) IRS Letter Ruling 9923007 (6/16/99).

(33) IRS Letter Ruling 9917070 (1/25/99).

(34) IRS Letter Rulings 9917017 (1/19/99), 9917019 (1121/99), 9917055 (2/2/99), 9919010 (1/14/99) and 9919011-15 (all dated 2/2/99).

(35) IRS Letter Ruling 9917029 (1/28/99).

(36) IRS Letter Ruling 9906002 (10/19/98).

(37) IRS Letter Ruling 9921022 (2123/99).

(38) IRS Letter Ruling 9851041 (9/17/98).

(39) IRS Letter Ruling 9831027 (5/6/98).

(40) IRS Letter Ruling 9924018 (3/17/99).

(41) IRS Letter Ruling 9909023 (12/1/98).

(42) IRS Letter Ruling 9907009 (11/16/98).

(43) IRS Letter Ruling 9909026 (12/1/98).

(44) IRS Letter Ruling 9909012 (11/25/98).

(45) IRS Letter Ruling 9907012 (11/18/98).

(46) IRS Letter Ruling 9921009 (2/17/99).

(47) See Diamond, "Post-TRA '97 S Corps. and ESOPs--An Ideal Combination," 30 The Tax Adviser 46 (January 1999).

(48) TD 8806 (1/7/99).

(49) IRS Letter Ruling 9918031 (2/3/99).

(50) IRS Letter Ruling 9904008 (10/26/98).

(51) FSA 1998-326 (10/19/98).

(52) Bakersfield Westar, Inc., 9th Cir. BAP, 10/16/98 (83 AFTR2d 98-6877, 98-2 USTC [paragraph] 50,843).

(53) IRS Letter Ruling 9823016 (3/4/98).

(54) IRS Letter Ruling 9909011 (11/25/98).

(55) Donald J. Peracchi, 143 F3d 487 (9th Cir. 1998)(81 AFTR2d 98-1754, 981 USTC [paragraph] 50,374), rev'g TC Memo 1996-191.

Hughlene A. 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 University San Jose, CA3