Eligibility, elections and terminations. .
Eligibility, Elections and Terminations
The general definition of an S corporation in Sec. 1361 includes restrictions on the types and number of shareholders, as well as the kinds of corporations, that qualify for the election. 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.
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). However, in Letter Ruling 200211023, (22) the IRS granted S status from the date of incorporation, even though it had no record of receiving Form 2553 and there was no proof the taxpayer mailed it.
Rev. Proc. 98-55 (23) grants S corporations a 12-month automatic extension to file Form 2553 without obtaining a letter ruling, thus avoiding the user fee. Nonetheless, the IRS continues to receive numerous letter ruling requests (24) on late filing of Form 2553. In all instances, the IRS allowed S status from inception under Sec. 1362(b)(5), as long as the taxpayer fried a valid Form 2553 within 60 days of the ruling. In some cases, (25) Form SS-4, Application for Employer Identification Number, and Form 1120S, U.S. Income Tax Return for an S Corporation, had been fried indicating the corporation was an S corporation; however, Form 2553 was not filed prior to the ruling request.
In other rulings, (26) a general manager, lawyer, accountant, tax preparer or financial consultant forgot to complete or mail Form 2553, but the company filed an S return and the shareholders included the income on their individual returns. 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 it. If the election is to be retroactive to the beginning of the year, Sec. 1362(b)(2)(B) requires all who owned stock that year (before the election) to also sign. In Letter Ruling 200205024, (27) an S corporation filed Form 2553 with certain shareholders' signatures missing. In addition, nonvoting shares of stock were inadvertently issued to a partnership (an ineligible shareholder); when this matter was discovered, the shares were reissued to the individual partners and the corporation's return was amended. The Service determined the S election was inadvertently invalid (for failure to attach certain shareholder consents) and inadvertently terminated (by the stock issuance to the partnership), but allowed the corporation to retain S status.
Another issue is who must sign Form 2553 when a trust is a shareholder. The trust beneficiary or his or her legal representative should sign the form, not the trustee (except for an ESBT, for which the trustee signs the form). In Letter Ruling 200144023, (28) a trustee of family trusts signed Form 2553 as the trustee, not as a deemed owner. The Service determined the improper execution of the shareholder consents was inadvertent.
In Letter Ruling 200148031, (29) a C corporation's shareholders were four individuals and seven ESBTs. At the same time the corporation made an S election, seven more ESBTs (for the same beneficiaries) were established as shareholders. When Form 2553 was filed, the trustee for the 14 trusts signed the consent statement seven (not 14) times, as owner of the trusts, not as trustee. The IRS determined the election was inadvertently invalid and granted S status.
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. Treasury issued final regulations (30) on adopting, changing or retaining annual accounting periods; in conjunction with the regulations, the IRS issued three pertinent revenue procedures. (31) Rev. Proc. 2002-38 (32) provides exclusive ways for S corporations to obtain automatic approval to adopt, change or retain an annual accounting period. An S corporation that complies with the procedure is deemed to have established a business purpose and obtained IRS approval to adopt, change or retain an annual accounting period.
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 Letter Ruling 200201005, (33) the owners of a grantor trust that was an S corporation's sole shareholder formed a general partnership by transferring the S stock to the partnership. Elections were made to treat the (1) partnership as an association taxable as an S corporation and (2) S corporation as a qualified subchapter S subsidiary (QSub). The partnership later contributed 1% of the S stock to a newly formed limited liability company (LLC) wholly owned by the partnership (a disregarded entity). The partnership agreement required all distributions to be made to the partners in the same proportion as their ownership interests. The IRS ruled that the (1) partnership would be taxed as an S corporation and (2) transaction did not create a second class of stock.
In another ruling, (34) an S corporation had an agreement with its shareholders that restricted stock transfers and required them to assign all distributions to the company and to sell their stock back to the company on leaving. Fearing the agreement created a second class of stock, the company amended it as to distributions. The Service concluded that, although the original agreement created a Second class of stock (invalidating the S election), the amended agreement did not. The Service thus allowed the company to retain S status, because the election was inadvertently invalid. In Letter Ruling 200130008, (35) the Service ruled that a nonqualifed deferred compensation arrangement's provision for incentive shares did not create a second class of stock.
In another case, (36) a C corporation had created an employee stock ownership plan. In anticipation of converting to S status, the trust holding the stock bought the remainder of the company's stock under a purchase agreement that contained a "floor put right" on future stock purchases. The Service determined that the agreement did not create a second class of stock.
A state law partnership can elect to be taxed as a corporation. However, if the partnership has both general and limited partners, differences in rights and obligations may create a second class of stock. The IRS is studying this issue, which has been added to the no-advance-rulings area. (37) In several situations, (38) an S corporation converted to a state law partnership, but converted back to an S corporation when it learned that the conversion might create a second class of stock. The Service ruled in each case that the temporary conversion did not terminate the initial S election.
An S corporation may own another S corporation only if it files a QSub election for the wholly owned subsidiary with the service center where the subsidiary filed its most recent return. The election should be filed on Form 8869, Qualified Subchapter S Subsidiary Election, by the fifteenth day of the third month after the date the election is to be effective. Many of the rulings (39) involved the late filing of a QSub election. In each case, the Service determined there was good cause for the delay and granted a 60-day extension to make the election.
If an S corporation has accumulated subchapter C earnings and profits (AEP), it must carefully monitor the composition of its gross receipts, for two reasons. First, if it does not eliminate the AEP, and has excess passive investment income (PII) (i.e., more than 25% of gross receipts) for three consecutive years, its 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 rulings (40) addressed rentals from industrial buildings, apartment complexes and commercial buildings and concluded the income was active, whether the property was owned directly or indirectly
Several PII cases did not deal exclusively with rental real estate. In Letter Rulings 200147034 (41) and 200144021, (42) an S corporation wanted to diversify and increase its liquidity by investing in a publicly traded partnership (PTP) taxed as a partnership. The Service concluded that the S corporation's share of the gross receipts from a partnership, attributable to purchasing, gathering, transporting, trading, storing and reselling crude oil, refined petroleum and other chemical products, were not PII under Sec. 1362.
In Letter Ruling 200217045, (43) an S corporation was in the business of crop share farming and timber harvesting. Under an agreement, the company received a portion of all the income from farming operations and participated in all management decisions. The Service determined that income from the agreement was not PII.
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. Each year, numerous rulings address inadvertent termination when an ineligible shareholder has acquired S stock.
In Letter Ruling 200147045, (44) an S corporation issued shares to a limited liability partnership (LLP), an ineligible shareholder. The corporation redeemed the shares after the mistake was discovered. The Service ruled the termination was inadvertent; the corporation was allowed to retain its S status. However, the LLP was deemed to be a shareholder for the period it owned the S stock and had to report its share of S income on its partnership return.
In two rulings, (45) IRAs acquired the S stock. In the first ruling, a routine planning meeting revealed that an IRA owned S shares. After the discovery, the IRA distributed the stock to the IRA owner in a taxable transaction. The Service determined the S election was inadvertently invalid and allowed the company to retain S status. In the second case, on noting the error, the S corporation redeemed the stock from the IRA. Because the issuance was not for tax avoidance or retroactive tax planning purposes, the IRS ruled the termination inadvertent.
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. The IRS ruled in several cases whether a trust would qualify as an S shareholder.
QSSTs: In Letter Ruling 200147043, (46) a taxpayer created a qualified terminable inierest property trust and planned to make a qualified subchapter S trust (QSST) election. However, the trust's income beneficiary was ineligible to make the election, because the trust grantor owned only the income portion, not the entire trust. Thus, the trust was not a grantor trust and ineligible to own S stock. The taxpayer immediately reformed the trust to be an eligible shareholder. The Service ruled the termination inadvertent.
In three rulings, (47) a taxpayer created an irrevocable trust and transferred S stock to it. The trust elected to be a QSST and purchased additional S shares under a stock purchase agreement. The QSST also executed a dividend agreement with the company. The Service ruled that the execution of the stock purchase and dividend agreements did not affect the trust's qualification as a QSST.
For both QSSTs and ESBTs, the trust must make a separate election to qualify as an S shareholder. This election is often filed incorrectly, requiring an inadvertent termination ruling. In several instances, (48) a beneficiary intended to treat a trust as a QSST. Although the trust met the QSST requirements, the beneficiary failed to file the election. The IRS determined that there was good cause for the failure and granted a 60-day extension to make the election.
In another ruling, (49) an S shareholder created a trust that he intended to be a QSST, but never made the election. The trust did not meet the QSST requirements. The taxpayer petitioned a court to reform the trust to meet the requirements, which was granted. The IRS ruled that the transfer of the S stock to the trust inadvertently terminated the S election.
One requirement for a QSST is that it distribute all of the trust's income annually. In Letter Ruling 200147046, (50) an S shareholder was a trust that did not make such annual distributions; thus, it did not qualify as a QSST. When the S corporation realized the problem, the trustee took immediate remedial action. The IRS ruled the termination of S status was inadvertent.
ESBTs: In another ruling, (51) an S shareholder created grantor trusts that he intended to be ESBTs. However, the IRS did not receive the ESBT election. The taxpayer received an IRS notice accepting a QSST election for the trusts, even though they were ineligible. The Service ruled that the S election inadvertently terminated when the stock was transferred to the trust; it allowed the corporation to retain S status as long as the ESBT election was made within 60 days of the ruling.
Because the QSST requirements are quite restrictive, the Small Business Job Protection Act of 1996 (SBJPA) added ESBTs as eligible S shareholders. Treasury issued final regulations on ESBT qualification and treatment. (52) The regulations explain who is an ESBT beneficiary (to be counted in the number of permitted shareholders) and define a potential current beneficiary. The regulations do not allow any part of an interest in an ESBT to be purchased and clarify that this ban applies to purchases of a beneficiary's interest in the trust, not to purchases of property by the trust. The regulations also allow a grantor trust to be an ESBT.
Under the new rules, the ESBT election and the election to convert from an ESBT to a QSST (and vice versa) is made by filing a statement with the service center where the S corporation's tax return is filed. Thus, the final regulations establish a consistent filing location for all trust elections. Unlike with a QSST, a protective ESBT election is not allowed.
Additionally, the final regulations 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. However, an S corporation that had previously made a Sec. 444 election can request that the IRS disregard the termination and permit the entity to continue to use the same fiscal year, that it used under Sec. 444. The new regulations generally apply to tax years ending after Dec. 28, 2000; a taxpayer may voluntarily apply them to tax years beginning after 1996.
Treasury also issued proposed regulations (53) on the QSST election for testamentary trusts. The proposed regulations incorporated changes made by the SBJPA to provide that a testamentary trust can be a permitted shareholder for up to two years.
Revocations and Terminations
Assuming that a revocation or termination of S status is not deemed inadvertent, a company must wait five years before it may re-elect S status, under Sec. 1362(g). The IRS issued two rulings (54) permitting a less-than-five-year wait before re-electing S status.
In the first case, an S corporation and a C corporation were under common ownership; the two entities merged. Within five years of the merger, the C corporation sought to make an S election. The Service determined that the restriction on re-election did not apply to the C corporation; thus, it could make the S election without prior approval.
In the second case, an S corporation acquired most of the assets of another company in exchange for its stock. As part of the agreement, the stock was to be immediately distributed to the C corporation's shareholders. The company failed to distribute the stock, terminating the S election. The Service allowed the corporation to re-elect S status within five years, because the termination was not within the entity's control.
(22) IRS Letter Ruling 200211023 (12/14/01).
(23) Rev. Proc. 98-55, 1998-2 CB 645.
(24) See, e.g., IRS Letter Rulings 200204009 (10/18/01) and 200140044 (7/6/09).
(25) See, e.g., IRS Letter Rulings 200215040 (1/14/01) and 200148027 (8/27/01).
(26) See, e.g., IRS Letter Rulings 200217018 (1/17/02) and 200210052 (12/11/01).
(27) IRS Letter Ruling 200205024 (10/29/01).
(28) IRS Letter Ruling 200144023 (8/6/01).
(29) IRS Letter Ruling 200148031 (8/28/01).
(30) TD 8996 (5/16/02).
(31) Rev. Procs. 2002-37, IRB 2002-22, 1030; 2002-38, IRB 2002-22, 1037; and 2002-39, IRB 2002-22, 1046.
(32) Rev. Proc. 2002-38, note 31 supra, clarifying and superseding Rev. Proc. 87-32, 1987-2 CB 396.
(33) IRS Letter Ruling 200201005 (9/27/01); see also IRS Letter Rulings 200215006 (12/22/01) and 200221035 (2/21/02).
(34) IRS Letter Ruling 200217048 (1/24/02).
(35) IRS Letter Ruling 200130008 (4/20/01).
(36) IRS Letter Ruling 200205044 (11/7/01).
(37) See Rev. Proc. 2002-3, IRB 2001-1, 117, section 5.04.
(38) IRS Letter Rulings 200149027 (9/5/01), 200146051 (8/21/01) and 200144016 (8/2/01).
(39) See, e.g., IRS Letter Rulings 200208006 (11/15/01), 200205022 (10/26/01) and 200204028 (10/23/01).
(40) See, e.g., IRS Letter Rulings 200217034 (1/23/02), 200203017 (10/11/01), 200218033 (2/5/02) and 200206023 (11/7/01).
(41) IRS Letter Ruling 200147034 (8/17/01).
(42) IRS Letter Ruling 200144021 (8/1/01).
(43) IRS Letter Ruling 200217045 (1/24/02).
(44) IRS Letter Ruling 200147045 (8/22/01).
(45) IRS Letter Rulings 200206011 (11/1/01) and 200203057 (10/19/01).
(46) IRS Letter Ruling 200147043 (8/21/01).
(47) IRS Letter Rulings 200140040, 200140043 and 200140046 (all dated 7/5/01).
(48) IRS Letter Rulings 200205004 (10/22/01), 200204027 (10/23/01) and 200140050 (7/6/01).
(49) IRS Letter Ruling 200216008 (1/15/02).
(50) IRS Letter Ruling 200147046 (8/22/01).
(51) IRS Letter Ruling 200148035 (8/29/01).
(52) TD 8994 (5/13/02).
(53) REG-106431-01 (8/24/01).
(54) IRS Letter Rulings 200218017 (1/29/02) and 200147038 (8/20/01).
RELATED ARTICLE: EXECUTIVE SUMMARY
* Final regulations and several revenue procedures were issued on adopting, changing or retaining an S corporation's annual accounting period.
* Final regulations address ESBTs.
* Several rulings dealt with one vs. two classes of stock.
Editor's note: Dr. Karlinsky is a member of the AICPA Tax Division's S Corporation Taxation Technical Resource Panel (TRP). Dr. Burton is a member of the AICPA Tax Division's Partnership Taxation TRP.
Stewart S. Karlinsky, Ph.D., CPA Graduate Tax Director San Jose State University San Jose, CA
Hughlene Burton, Ph.D., CPA Associate Professor University of North Carolina--Charlotte Charlotte, NC
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|Title Annotation:||part 2; S Corporations|
|Publication:||The Tax Adviser|
|Date:||Nov 1, 2002|
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