This article, the second of two parts, provides an annual update of recent IRS rulings, guidance, and other developments concerning S corporations. It discusses S corporation eligibility, elections, and termination issues, including passive investment income. It also covers significant issues related to second class of stock, trusts owning S corporation stock, and numerous letter rulings on corporate and shareholder eligibility. The first part, in the October issue, examined recent S corporation operational issues. This update covers July 1, 2010–June 30, 2011.
Eligibility, Elections, and Terminations
The general definition of an S corporation includes restrictions on the type and number of its shareholders as well as the type of corporation that qualifies for the election. If an S corporation violates any of these restrictions, its S status is terminated automatically. However, the taxpayer can request an inadvertent termination relief 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 relief for inadvertent late or erroneous elections and inadvertent terminations, and it is clear from the rulings presented here and in past years that the IRS has abided by congressional intent.
When to make an S election and when and whether that election should be terminated are important issues that a corporation must observe. In August 2010, Treasury issued temporary and proposed regulations concerning deferral of income recognition from discharge of business indebtedness under Sec. 108(i) 1 that could affect these tax planning decisions. Under these new temporary and proposed regulations, both the election of S status and the termination of a corporation’s S status can be considered an event that accelerates otherwise deferred recognition. Thus, practitioners must be aware that either of these decisions could affect shareholders. Under these regulations, it is more important than ever to make sure that potentially affected S corporations maintain their status.
In an attempt to reduce the number of requests for relief from late filings, the IRS issued Rev. Proc. 2003-43, 2 which grants S corporations, qualified subchapter S subsidiaries (QSubs), electing small business trusts (ESBTs), and qualified subchapter S trusts (QSSTs) a 24-month extension to file Form 2553, Election by a Small Business Corporation; Form 8869, Qualified Subchapter S Subsidiary Election; or a trust election without obtaining a letter ruling. Rev. Proc. 2007-62, 3 which supplements Rev. Proc. 2003-43, provides an additional method for certain taxpayers to request relief for a late S corporation election and a late corporate classification election that is intended to be effective on the same day. To obtain relief under Rev. Proc. 2007-62, the corporation must file a properly completed Form 2553 with its Form 1120S, U.S. Income Tax Return for an S Corporation, for the first year the corporation intended to be an S corporation with a statement explaining the reason for the failure to file a timely election.
It appears that the intent of the revenue procedures is working. Even though the IRS continues to receive late-filing requests, 4 it issued far fewer rulings in the period covered by this update than in the past. In most of those it did issue, the IRS allowed S status under Sec. 1362(b)(5) as long as the taxpayer filed a valid Form 2553 within 120 days of the ruling. In the past, S corporations had been allowed only 60 days. In several other situations, 5 the IRS ruled that a late filing was inadvertent and granted the corporation relief but did not rule on whether the entity would otherwise qualify for S corporation treatment. Thus, these companies may still have some issues to resolve to make sure the S election was valid.
In most private letter rulings on timely elections during this period, the taxpayer was granted relief under Sec. 1362(b)(5) if it could establish reasonable cause for the failure to make a timely election and show that granting the relief would not prejudice government interests. However, in Letter Ruling 201123013, 6 the taxpayer did not establish reasonable cause, and the IRS denied relief. In this ruling, the taxpayer originally planned to be a tax-exempt entity but failed to complete the application. The company then decided to be an S corporation but did not file a timely Form 2553. This appears to have been a case of the taxpayer’s not knowing which type of entity it wanted to be, so it ended up as neither.
In Letter Ruling 201123021, 7 the shareholders made several wrong steps. First, the corporation planned to be an S corporation but did not file a timely Form 2553. In addition, the shareholders executed a formal shareholder agreement that may have unintentionally created a second class of stock. Also, the corporation’s stock was purchased by another corporation that was an ineligible shareholder. The corporation and the shareholders filed their tax returns as if the company were an S corporation. For all three missteps, the IRS ruled that the S election was terminated inadvertently and allowed the company to retain its S status.
Sometimes an entity is formed as a limited liability company (LLC) or a limited liability partnership but wishes to be treated as an S corporation. In the past, the entity had to file both Form 8832, Entity Classification Election, and Form 2553. However, Regs. Sec. 301.7701-3(c)(1)(v)(C) eliminates the need to file Form 8832. Instead, a partnership or disregarded entity that would otherwise qualify to be an S corporation and makes a timely and valid S corporation election on Form 2553 will be deemed to have elected to be classified as an association taxable as a corporation. Even though the regulations do not require a corporation to file Form 8832 when the election is made, the corporation must attach a copy to its first tax return.
Nonetheless, in several instances 8 this year, entities failed to file either of the elections (Form 2553 or Form 8832). In all these instances, the IRS granted relief and allowed the entities S status from inception, as long as they filed both forms within 120 days of the ruling.
Who signs Form 2553: To qualify as an S corporation, the corporation and all its shareholders as of the date of the election (as well as affected former shareholders) must timely file a valid Form 2553. This election should be sent by certified mail (return receipt requested), registered mail, or an approved private delivery service (e.g., FedEx, DHL, or UPS). This year in several situations, a corporation did not obtain consent from the appropriate shareholders to make the S election.
In one ruling, 9 the company filed Form 2553 correctly but did not include a valid required QSST election. The IRS concluded that the company’s S corporation election was invalid under Sec. 1362(a)(2) because a QSST election for a trust shareholder was not included. However, the invalidity of the S corporation election was inadvertent under Sec. 1362(f), and the IRS said it would treat the company as an S corporation and the trust as a QSST if the trust filed a new QSST election within 120 days.
In another instance, 10 a corporation elected to be treated as an S corporation but failed to obtain consent from two of its shareholders, making the S corporation election invalid. When the corporation discovered the problem, it sought relief. The IRS concluded that the election constituted an inadvertent ineffective election within the meaning of Sec. 1362(f) and said the corporation would be treated as an S corporation from the election’s original date, as long as the two shareholders filed a signed consent indicating that it was associated with the original Form 2553.
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 (those allowed a tax credit for income from Puerto Rico and U.S. possessions). In addition, there are restrictions on who may own the stock of an S corporation and the type of stock an S corporation can issue.
One Class of Stock
Sec. 1361(b)(1)(D) prohibits an S corporation from having more than one class of stock. A corporation has one class of stock if all outstanding shares of its stock confer identical rights to distribution and liquidation proceeds (but not necessarily equal voting rights). Under the facts of Letter Ruling 201043015, 11 an S corporation had class A voting common and class B nonvoting common stock outstanding. The company stated that the two classes of stock differed only as to voting rights and that each share had identical rights to distribution and liquidation proceeds. The company’s normal business operations involved borrowing funds from commercial lenders. In connection with a debt restructuring and as consideration for their consent, some lenders received warrants to acquire nonvoting common stock. The warrants were subject to various conditions, put and call rights, and antidilution provisions. The company maintained that the primary purpose for issuing the warrants was to secure consent and restructuring participation by the lenders on terms typical to such transactions. The IRS determined that the warrants came within the exception in Regs. Sec. 1.1361-1(l)(4)(iii)(B)(1) and did not create a second class of stock. A similar situation with the same results can be found in Letter Ruling 201104008. 12
In another scenario, 13 an S corporation sold shares of its stock to a trust, an eligible S corporation shareholder. Under the purchase agreement, the shares were of the same class and had the same rights and titles as the remaining outstanding shares. However, the purchase agreement contained a clause that allowed the trust to receive up to the full value of its initial investment in the event a sale of the S corporation resulted in a loss. The purchase agreement was amended to remove this clause and eliminate any second class of stock. No payment was ever made under the clause. The IRS concluded that the S corporation election may have inadvertently terminated because the corporation may have had more than one class of stock. However, the IRS ruled that if the S election was terminated, such a termination was inadvertent within the meaning of Sec. 1362(f) and it would treat the corporation as having continuously been an S corporation.
In Letter Ruling 201131015, 14 an S corporation issued a second class of stock, which triggered a termination of the company’s S election. Upon discovering the terminating event, the company took steps so that it again qualified as an S corporation. It then asked the IRS to rule that the termination was inadvertent within the meaning of Sec. 1362(f) and that it would continue to be treated as an S corporation despite the terminating event. The IRS granted the relief.
Several S corporations made disproportionate distributions resulting in classes of stock with different distribution and liquidation rights, thus terminating the corporations’ S elections. In each situation, the IRS determined that the corporation had terminated its S election because of the disproportionate distributions but that the termination was inadvertent. In one instance, 15 an S corporation failed to make distributions to one of its four shareholders, although it had only one class of common stock outstanding. When the S corporation discovered that its S election may have terminated because of the disproportionate distributions, it sought relief, advising the IRS that it did not intend to create a second class of stock or to terminate its S election. The IRS determined that the termination was inadvertent and that the corporation would be treated as continuing to be an S corporation, contingent upon the three other shareholders issuing notes to the corporation in repayment of their disproportionate distributions.
In Letter Ruling 201102033, 16 although the S corporation’s governing instruments provided that all shareholders had identical distribution and liquidation rights, the corporation made disproportionate distributions to its shareholders. When the company discovered that the disproportionate distributions terminated its S status, it proposed to make remedial distributions, and the IRS granted relief contingent upon the corporation’s making the remedial distributions.
In another ruling, 17 an S corporation remitted state taxes on behalf of its shareholders who were not residents of that state. Those payments were not treated as constructive distributions to the shareholders, which caused distributions to be disproportionate. The corporation stated that it was not aware that its failure to treat the tax payments as constructive distributions could cause the company to have a second class of stock and that it did not intend to terminate its S corporation election. The IRS ruled that the termination was inadvertent under Sec. 1362(f) and that it would continue to treat the company as an S corporation.
In a similar situation, 18 an S corporation made disproportionate distributions to its shareholders to defray income taxes attributable to the company’s income. It later learned that these distributions were not consistent with its governing instruments and could be construed to create a second class of stock. The company made corrective distributions to its shareholders to eliminate the cumulative amount of the disproportionate distributions. The IRS concluded that the company had more than one class of stock due to the disproportionate distributions but that the termination was inadvertent.
In Letter Ruling 201104019, 19 an S corporation made incorrectly disproportionate allocations of income and distributions to its shareholders, thereby creating two classes of common stock outstanding during that period, though both classes had identical rights to distribution and liquidation proceeds. When the S corporation discovered that the existence of two classes of stock might have terminated its S status, it sought a ruling under Sec. 1362(f) that any termination was inadvertent. The IRS ruled that if there was a termination it was inadvertent and that the corporation remained an S corporation.
In yet another instance, 20 the corporation declared a pro-rata dividend at the end of each year equal to its estimated taxable income. However, in the years the corporation’s cashflow was inadequate to cover the declared dividend, it treated the shortfall as a deemed distribution to its shareholders, followed by a loan from the shareholders back to the company. The company then loaned money to one of its shareholders. Later, the shareholder paid off the loan payable to the corporation by offsetting the dividend otherwise due to it for the year. The S corporation became aware that the shareholder loans might have created a second class of stock terminating the S election. The IRS ruled that the S corporation election might have been terminated because it had more than one class of stock as a result of the transactions but that the termination was inadvertent, and the corporation would continue to be treated as an S corporation, contingent upon its paying any remaining interest it owed to shareholders within 120 days of the IRS’s letter.
An S corporation may own an 80% or greater interest in a subsidiary (domestic or foreign) but may not file a consolidated tax return with the subsidiary. However, if the domestic subsidiary is a 100% owned S corporation, it is eligible to be treated as a QSub, branch, or division of the parent S corporation. In order for a subsidiary to be treated as a QSub, the parent corporation must file an election 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 policy is consistent with Rev. Proc. 2004-49, 21 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 in which the QSub was created. Despite this, companies have still requested 22 relief for late filing of a QSub election. In each of these, the IRS determined that the taxpayers had shown good cause for the delays and granted an extension of 120 days from the ruling date to make the election.
In Letter Ruling 201104030, 23 an S corporation made a QSub election for its subsidiary, but the election was ineffective because of unspecified procedural defects. Later, the subsidiary was dissolved. The S corporation sought a ruling that the subsidiary would be treated as a QSub for the period between the subsidiary’s formation and dissolution, despite the defective election. The S corporation claimed that the ineffective QSub election was not motivated by tax avoidance or retroactive tax planning and that it and its shareholders would make any needed adjustments. The IRS granted relief, finding that the ineffective QSub election was inadvertent within the meaning of Sec. 1362(f).
Earnings and Profits
If an S corporation has subchapter C accumulated earnings and profits (AE&P), it is 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 have dealt with whether rental real estate activities were active or passive for purposes of the tax. Under Regs. Sec. 1.1362-2(c)(5)(ii)(B), rents that a corporation receives are treated as from an active trade or business of renting property only if the corporation provides significant services or incurs substantial costs in the rental business. Since issuing the regulations, the IRS has been lenient in its definition of passive income; as a result, the number of ruling requests is down significantly. In 2011, the IRS put this issue on the no-ruling list, 24 so there should be very few ruling requests in the future.
Over the past year, income from commercial and residential rentals was deemed in two letter rulings to be active income. 25 The S corporations provided various services to tenants, such as utilities and maintenance for common areas, landscaping, garbage removal, and security. The S corporations also handled leasing and administrative functions, including billing, rent collection, finding new tenants, and negotiating leases. In a similar situation, 26 the IRS ruled that rental income that an S corporation received from its own properties and properties owned by two subsidiaries the S corporation owned and an LLC in which it was a member was active income.
Sec. 1362(d)(3) Terminations
Under Sec. 1362(d)(3), a corporation may have its S status terminated if it has AE&P and its passive investment income exceeds 25% of its gross receipts for three consecutive years. For this reason, the IRS issued several rulings on termination of S status.
In Letter Ruling 201046011, 27 an S corporation that had AE&P received passive investment income within the definition of Sec. 1362(d)(3) in excess of 25% of its gross receipts. To correct the problem, the company elected to distribute all its AE&P to its shareholders. In fact, however, it had not distributed all its AE&P due to a miscalculation. In requesting relief from termination of its S status, the company represented that the circumstances resulting in the termination of its S election were inadvertent and were not motivated by tax avoidance or retroactive tax planning, that the shareholders had filed tax returns consistent with S status, and that both the company and the shareholders agreed to make any required adjustments. The IRS granted relief under Sec. 1362(f). The IRS also granted relief in a case with similar facts in Letter Ruling 201110001. 28
Sec. 1361(b) restricts ownership in an S corporation to U.S. citizens, resident individuals, estates, certain trusts, certain pension plans (but not IRAs), and certain tax-exempt charitable organizations. In several rulings during the year, 29 after a corporation made an S election, it had an ineligible shareholder, and the resulting termination of the S election was discovered. In each case, the corporation took steps to qualify again as an S corporation. The IRS concluded that the S election terminated when the ineligible person or entity became a shareholder but that this termination was inadvertent and not motivated by tax avoidance.
In Letter Ruling 201106005, 30 an S corporation started an equity incentive plan under which it could award key employees participation units convertible into cash payments and some employees could become entitled to awards of cash and stock. An employee who was an ineligible S corporation shareholder became entitled to a cash and stock award. Before any actual stock transfer, however, the S corporation became aware of the employee’s ineligibility and did not transfer the stock. The corporation sought, and the IRS granted, a ruling that although its election may have terminated, the termination was inadvertent and the corporation would continue to be treated as an S corporation.
In another instance, 31 a company incorporated under state law and subsequently elected S status. Two shareholders thereafter transferred their shares to an ineligible S shareholder. The transfer triggered the termination of the company’s S status. When it made this discovery, the ineligible shareholder distributed the shares to the two shareholders consistent with their original ownership. The company claimed that the termination was inadvertent within the meaning of Sec. 1362(f) and requested relief, which the IRS granted on condition that the shareholders include in income their pro-rata share of affected items.
In another situation, 32 a corporation filed an S corporation election. After it filed the election, the company discovered that one shareholder was a corporation (an ineligible shareholder), so the company’s election was ineffective. Shortly thereafter, the corporation transferred its stock to individual owners, presumably curing the defect. The S corporation then asked for, and the IRS gave, a ruling that the ineffectiveness of the election was inadvertent and the corporation would continue to be treated as an S corporation.
Practice tip: The IRS did not address the taxability of the second transfer of stock in either of the last two rulings discussed. It is important for the tax adviser in this type of situation to try to structure the transaction as a redemption and not a dividend.
In Letter Ruling 201102046, 33 during a tax-free reorganization under Sec. 368(a)(1)(D), the new corporation held S corporation stock. The IRS determined that, assuming the S corporation stock was distributed to eligible shareholders immediately after the contribution to the new company, the corporation’s momentary ownership of the S stock would not cause the S corporation to have an ineligible shareholder for any portion of its first tax year.
In Letter Ruling 201040001, 34 an S corporation transferred shares to a resident alien. Afterward, the shareholder’s status as a resident alien was revoked, causing the corporation’s S election to terminate. Upon discovery of the problem, the corporation promptly redeemed all the shares it had issued to the now nonresident alien. The IRS concluded that the S corporation election terminated when the shareholder became a nonresident alien. However, this termination was inadvertent, and thus the IRS ruled it would treat the company as an S corporation, provided that the election was valid and was not otherwise terminated.
A partnership or LLC is another ineligible S corporation shareholder. In Letter Ruling 201048026, 35 an S corporation’s shareholders sold their stock to an LLC owned by two individuals, which terminated the S election. When the individuals realized that the S election had terminated, the LLC transferred the S corporation stock to the individuals, who were eligible S corporation shareholders. During this time, the S corporation and its shareholders filed tax returns consistent with the corporation’s being an S corporation. The IRS ruled the termination was inadvertent and granted relief on condition that all affected parties would make appropriate adjustments to all tax items.
In a similar letter ruling, 36 some of the shares of an S corporation’s stock were transferred to an LLC. Because the LLC was an ineligible shareholder, the S election terminated upon the transfer. When the ramifications of the LLC’s ownership were discovered, the LLC transferred all its S corporation stock to an eligible S corporation shareholder. The IRS determined that the termination was inadvertent and that the company would be treated as an S corporation the entire time, assuming the S corporation’s shareholders made all appropriate adjustments.
In another situation, 37 an LLC purchased all of an S corporation’s stock. The corporation later learned that the LLC was an ineligible shareholder and that its purchase of the stock had terminated the company’s S election. The LLC then distributed all the shares to its members in proportion to their ownership interests in the LLC on the date of the stock acquisition. In seeking relief, the corporation advised that some of the LLC’s members were eligible shareholders but that others, including a number of trusts, were not eligible because they had failed to elect to be ESBTs. The IRS granted relief, holding that the errors and omissions were inadvertent and that the corporation could retain its S status, provided that the trusts filed the needed ESBT elections within 120 days and that the LLC’s members made the required adjustments.
In Letter Ruling 201129010, 38 shares of an S corporation’s stock were similarly transferred to an LLC that was not an eligible shareholder. Upon discovering the problem, the LLC transferred the stock to one of its owners that was an eligible shareholder. None of the parties involved were aware that the LLC’s ownership of the S stock would terminate the S election. The IRS concluded that the termination was inadvertent and that the corporation would continue to be treated as an S corporation.
An IRA cannot be an S shareholder except in very limited circumstances. During the period covered by this update, the IRS ruled on several transfers of S corporation stock to an IRA. In one, 39 an S corporation issued its shares to an IRA. When the corporation discovered the error, it promptly redeemed all the shares that had been transferred to the IRA. The corporation then asked the IRS for a ruling that any resulting termination be deemed inadvertent and that it continue to be treated as an S corporation. The IRS granted the request on the condition that for any tax period during which the corporation had reported a net loss the IRA would be treated as the shareholder.
In another situation, 40 an S corporation sold shares to two IRAs, both of which were ineligible shareholders under Sec. 1361(b)(1)(B). After the S corporation learned that its election had terminated as a result, the IRAs transferred all of their S stock to an eligible shareholder. The IRS ruled that the S election terminated upon the transfer of shares to the IRAs, but the termination was inadvertent under Sec. 1362(f) and the corporation would continue to be treated as an S corporation. A similar ruling can be found in Letter Ruling 201114009, 41 in which the IRS determined that an IRA beneficiary would be treated as the shareholder of the S stock from the date the shares were originally issued to the IRA.
In another case, 42 a corporation’s S election was invalid because an IRA owned some of its stock. Later, the IRA became a permissible shareholder. The IRS determined that the invalid election was inadvertent and that the company was entitled to be treated as an S corporation. The IRS conditioned the ruling on the payment of an amount representing the treatment of the IRA’s beneficiary as a shareholder of the corporation for the interim period.
Certain trusts may own S stock but must follow strict rules. Therefore, an S corporation and its tax advisers must constantly monitor trust shareholders’ elections and trust agreements and their subsequent modifications for compliance with S eligibility rules. The IRS ruled in several situations on trusts as S shareholders.
In one situation, 43 after a corporation elected to be an S corporation, two of its shareholders transferred shares to a trust that was not a qualified shareholder, and the company’s S election terminated. When the termination was discovered, the trust distributed the stock to one of the original shareholders. The IRS concluded that the termination was inadvertent under Sec. 1362(f) and that the company would continue to be treated as an S corporation. The shareholder to whom the shares were transferred would be treated as directly owning the shares as of the date of their transfer to the trust and was required to file amended returns and pay any additional tax due.
In another ruling, 44 a shareholder of an S corporation transferred stock in the company to a trust, but when the trust no longer qualified as an eligible shareholder, the company’s S status terminated. The trust transferred its shares in the S corporation to a second trust, an eligible shareholder. The company maintained that the termination was inadvertent and was not motivated by tax avoidance or retroactive tax planning. The IRS agreed and said it would treat the company as an S corporation, provided that the election was valid and not otherwise terminated under Sec. 1362(d). The original shareholder would be treated as the owner of the stock from the date the first trust no longer qualified as an eligible shareholder until the date the stock was transferred to the second trust.
In one ruling, 45 stock was transferred to two testamentary trusts (Trust 1 and Trust 2) under the terms of the shareholder’s will. The assets of Trust 2 were to be divided and distributed to two additional trusts (Trust 3 and Trust 4) on the death of the shareholder’s spouse. However, after the shareholder’s death, the S corporation stock that should have been distributed to Trust 1 and Trust 2 was mistakenly distributed among Trust 1, Trust 3, and Trust 4, even though the shareholder’s spouse was alive. However, all items of S corporation income and loss that were allocated to Trust 3 and Trust 4 were treated as if the spouse were their sole income beneficiary. In addition, even though Trust 2 was eligible to be treated as a QSST, it did not make a timely election. Trust 1, Trust 3, and Trust 4 satisfied the requirements of an ESBT under Sec. 1361(e) but did not make timely elections either. The IRS determined that the termination of the company’s S election was inadvertent and that it would treat the company as continuing to be an S corporation, assuming the trusts filed the appropriate ESBT and QSST elections.
In a similar situation, 46 an S corporation shareholder established a revocable trust to which he transferred the S corporation stock. The shareholder died and the trust became irrevocable. The trust technically continued to be a qualifying S shareholder per Sec. 1361(c)(2)(A)(ii) for two years after the shareholder’s death. When the trust continued to hold the stock after that period, its presence as an ineligible shareholder terminated the company’s S election. A new trustee later transferred the stock from the trust to a second trust that the company said was eligible to be a QSST. The company asked the IRS to rule that its S status would continue, notwithstanding the terminating event; the IRS agreed, as long as the second trust filed a valid QSST election within 120 days.
Other Trust Issues
Election requirements: Trusts also sometimes fail to comply with the requirement that QSSTs and ESBTs must make the election to qualify as an eligible S shareholder. Often this election is filed incorrectly or untimely or is signed by the wrong party, and an inadvertent termination ruling is needed. This year in numerous instances 47 a trust was intended to be treated as a QSST or an ESBT and met all the requirements, but the trustee or beneficiary failed to file the election. The IRS determined in each case that there was good cause for the failure and granted a 120-day extension from the ruling date to make the election. In each of these cases, the ruling was contingent on the corporation’s having been treated as an S corporation from the time the trust received the stock until the date of the ruling. 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, the corporation and its shareholders were required to file amended tax returns.
In Letter Rulings 201114002 48 and 201041027, 49 the IRS addressed whether a trust can revoke its ESBT election and then be granted an extension of time to file a QSST election. In both cases, the IRS determined that the trust may revoke its ESBT election and granted an extension of 120 days from the date of the ruling to file a QSST election for the trust, effective on the same date as the revocation.
In two similar situations, 50 the sole shareholder of an S corporation owned the stock through a disregarded entity. The owner then transferred his interest in the disregarded entity to himself and a spouse as co-trustees of a joint living revocable trust that created separate trust shares for both the owner and the spouse. Only later did the owner discover that the transfer of the disregarded entity to the trust may have caused an inadvertent termination of the company’s S election. The IRS granted relief on finding that although the company’s S election may have technically terminated upon the transfer to the trust, any such termination was inadvertent within the meaning of Sec. 1362(f).
In a slightly different situation, 51 a shareholder’s will created a trust to hold stock in an S corporation. The trust elected to be an ESBT. The trust agreement provided that the income was to be divided into as many equal parts as there were grandchildren of the shareholder who were living or who had died leaving issue. Upon the death of the last living grandchild, the income of the trust was to be divided into as many equal parts as there were great-grandchildren of the shareholder who were living or who had died with issue. A court-ordered modification excluded the descendants of any child of the last living grandchild of the original shareholder born after a certain date. Upon the death of the last living grandchild, while some beneficiaries’ shares of the income of the trust would increase, no beneficiary’s share of the income would decrease. The IRS ruled that each income beneficiary’s share of the trust constituted a separate and independent share of the trust under Sec. 663(c) and that each separate share of the trust qualified as a QSST. The ESBT election for a separate share of the trust could be revoked by filing a QSST election for that share under Regs. Sec. 1.1361-1(m)(7).
Practice tip: Note that in such a situation each share in either the ESBT or the QSST will be treated as a separate shareholder. If the additional shares cause the total number of shareholders of the S corporation to exceed 100, the corporation will lose its S status. The tax adviser should keep an eye on the additional shares created.
In Letter Ruling 201119005, 52 under the terms of a shareholder’s will a trust became a shareholder in a corporation that made an S election. In addition, the income beneficiary of the trust made an election to treat the trust as a QSST. Upon the beneficiary’s death, the trust’s assets were divided into two shares, which the IRS ruled were substantially separate and independent under Sec. 663(c). Therefore, each share was treated as a separate trust for purposes of Sec. 1361(d). Provided that all the net income for each share was distributed currently to the applicable income beneficiary and each share was administered as a QSST, each share of the trust would qualify as a QSST during the life of the income beneficiary, the IRS ruled. Provided that the original trust’s QSST election was valid and not otherwise terminated, the income beneficiary of each share of the trust was a successive income beneficiary under Sec. 1361(d)(2)(B)(ii). Therefore, the beneficiary was not required to file a QSST election for the original trust’s QSST election and the corporation’s S status to continue.
One of the requirements for a trust to qualify as a QSST is that it distribute all of its income each year. In Letter Ruling 201047018, 53 an S corporation’s trust shareholder elected to be treated as a QSST. On the first day of the following year, the trust ceased to qualify as a QSST due to its failure to distribute all its income within the meaning of Regs. Sec. 1.643(b)-1. After the trust discovered the failure, it made a corrective distribution of all undistributed income. The IRS concluded that the termination of the company’s S election was inadvertent within the meaning of Sec. 1362(f) and that the corporation would continue to be treated as an S corporation.
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 corporation short years are treated as two separate tax years. In one instance, 54 a corporation terminated its S election. The company sought to reelect S status within five years. The IRS allowed the entity’s request because more than 50% of the stock was owned by a shareholder who did not own stock on the date of the termination. To make the ruling valid, the company had to file a new completed Form 2553 within 120 days of the ruling.
In another situation, 55 an S corporation converted its existing common stock into two classes of stock, thereby terminating its S election. Shareholders then sold stock to an employee stock ownership plan (ESOP). The shareholders did not make an election under Sec. 1042 (nonrecognition of gain on sale of qualified securities). The corporation later converted its two classes of stock into one class of common stock. Shareholders then sold additional shares to the ESOP. The entity thereafter requested permission to reelect S corporation status despite the fact that the five-year waiting period in Sec. 1362(g) had not yet expired. The IRS granted relief. Presumably because the stock transfers to the ESOP had resulted in the ESOP’s owning more than 50% of the entity’s stock, the IRS held that the entity had met its burden to show that consent to the new election was properly granted. However, the IRS conditioned its consent on the shareholders’ not making an election under Sec. 1042 as to their sale of stock to the ESOP. It also disclaimed any opinion as to whether the entity met the criteria in Sec. 1361(b).
Similarly, in Letter Ruling 201047007, 56 an S corporation established an ESOP prior to revoking its S election. After the revocation, a second company acquired 100% of the S corporation stock. The ESOP then purchased 100% of the shares of the second company from its shareholders. The new company wanted to reelect S status and make a QSub election for the first company within the five-year waiting period. The shareholders did not make an election under Sec. 1042 upon the sale of the shares of the second company to the ESOP, and the company would not consent to any such election under Secs. 4978 and 4979A. The IRS determined that the entities met the criteria and allowed the QSub election and the S corporation reelection contingent on the companies’ otherwise qualifying to be treated respectively as a QSub and an S corporation.
1 T.D. 9497; T.D. 9498; REG-144762-09.
2 Rev. Proc. 2003-43, 2003-1 C.B. 998.
3 Rev. Proc. 2007-62, 2007-2 C.B. 786.
4 See, e.g., IRS Letter Rulings 201129004 (7/22/11), 201121004 (5/27/11), 201115015 (4/15/11), 201051009 (12/23/10), and 201044002 (11/5/10).
5 IRS Letter Rulings 201126005 (7/1/11), 201121012 (5/27/11), 201104021 (1/28/11), and 201048027 (12/3/10).
6 IRS Letter Ruling 201123013 (6/10/11).
7 IRS Letter Ruling 201123021 (6/10/11).
8 IRS Letter Rulings 201127008 (7/8/11), 201119009 (5/13/11), 201104014 (1/28/11), and 201049023 (12/10/10).
9 IRS Letter Ruling 201127005 (7/8/11).
10 IRS Letter Ruling 201051008 (12/23/10).
11 IRS Letter Ruling 201043015 (10/29/10).
12 IRS Letter Ruling 201104008 (1/28/11).
13 IRS Letter Ruling 201042014 (10/22/10).
14 IRS Letter Ruling 201131015 (8/5/11).
15 IRS Letter Ruling 201042003 (10/22/10).
16 IRS Letter Ruling 201102033 (1/14/11).
17 IRS Letter Ruling 201105017 (2/4/11).
18 IRS Letter Ruling 201129023 (7/22/11).
19 IRS Letter Ruling 201104019 (1/28/11).
20 IRS Letter Ruling 201045010 (11/12/10).
21 Rev. Proc. 2004-49, 2004-2 C.B. 210.
22 See, e.g., IRS Letter Rulings 201103030 (1/21/11), 201043003 (10/29/10), and 201043006 (10/29/10).
23 IRS Letter Ruling 201104030 (1/28/11).
24 Rev. Proc. 2011-3, 2011-1 I.R.B. 111, §4.01.45.
25 IRS Letter Rulings 201125011 (6/24/11) and 201050002 (12/17/10).
26 IRS Letter Ruling 201118011 (5/6/11).
27 IRS Letter Ruling 201046011 (11/19/10).
28 IRS Letter Ruling 201110001 (3/11/11).
29 IRS Letter Rulings 201126009 (7/1/11), 201122001 (3/6/11), 201105025 (2/4/11), and 201050025 (12/17/10).
30 IRS Letter Ruling 201106005 (2/11/11).
31 IRS Letter Ruling 201110003 (3/11/11).
32 IRS Letter Ruling 201128019 (7/15/11).
33 IRS Letter Ruling 201102046 (1/14/11).
34 IRS Letter Ruling 201040001 (10/8/10).
35 IRS Letter Ruling 201048026 (12/3/10).
36 IRS Letter Ruling 201129009 (7/22/11).
37 IRS Letter Ruling 201103015 (1/21/11).
38 IRS Letter Ruling 201129010 (7/22/11).
39 IRS Letter Ruling 201046005 (11/19/10).
40 IRS Letter Ruling 201119022 (5/13/11).
41 IRS Letter Ruling 201114009 (4/8/11).
42 IRS Letter Ruling 201113004 (4/1/11).
43 IRS Letter Ruling 201045002 (11/12/10).
44 IRS Letter Ruling 201123012 (6/10/11).
45 IRS Letter Ruling 201117016 (4/29/11).
46 IRS Letter Ruling 201123023 (6/10/11).
47 See, e.g., IRS Letter Rulings 201129001 (7/22/11), 201117008 (4/29/11), 201108012 (2/25/11), 201106002 (2/11/11), and 201048020 (12/3/10).
48 IRS Letter Ruling 201114002 (4/8/11).
49 IRS Letter Ruling 201041027 (10/15/10).
50 IRS Letter Rulings 201123008 (6/10/11) and 201123010 (6/10/11).
51 IRS Letter Ruling 201122003 (6/3/11).
52 IRS Letter Ruling 201119005 (5/13/11).
53 IRS Letter Ruling 201047018 (11/26/10).
54 IRS Letter Ruling 201126025 (7/1/11).
55 IRS Letter Ruling 201117020 (4/29/11).
56 IRS Letter Ruling 201047007 (11/26/10).
Hughlene Burton is an associate professor and chair of the Department of Accounting at the University of North Carolina–Charlotte in Charlotte, NC, and is past chair of the AICPA Tax Division’s Partnership Taxation Technical Resource Panel. Stewart S. Karlinsky is a professor emeritus at San José State University in San José, CA, and an associate member of the AICPA Tax Division’s S Corporation Taxation Technical Resource Panel. For more information about this article, contact Dr. Burton at email@example.com or Dr. Karlinsky at firstname.lastname@example.org .