Part I of this two-part article, in the October issue, examined recent S corporation operational tax issues. Part II discusses S corporation eligibility, elections, and termination issues, including passive investment income, Sec. 108(i) elections, and a new case that may be helpful to practitioners in the S corporation area. It covers significant issues related to second class of stock, trusts owning S corporation stock, and numerous letter rulings on corporate and shareholder eligibility. This tax update covers the period July 2009–July 2010.
Eligibility, Elections, and Terminations
The general definition of an S corporation includes restrictions on the type and number of shareholders, as well as the type of corporation that may qualify for the election. If an S corporation violates any of these restrictions, its S status is 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 inadvertent election and termination relief, 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 if that election should be terminated are important issues that a corporation must observe. This year Treasury issued temporary and proposed regulations under Sec. 108(i) 1 that could affect these decisions. Currently, under Sec. 108(i) corporations can elect to defer the recognition of cancellation of indebtedness unless an acceleration event occurs. Under the new temporary and proposed regulations, both the election of S status and the termination of a corporation’s S status would be considered an accelerating event. Thus, practitioners must be aware of the fact that either of these decisions could have a major impact on the shareholders due to the acceleration of income. Under these regulations, it will also be more important than ever to make sure that an S corporation maintains its 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 less than a third of the pre-procedure filings. In all the rulings this year, the IRS allowed S status under Sec. 1362(b)(5) as long as the taxpayer filed a valid Form 2553 within 60 days of the ruling.
In several other situations, 5 the IRS ruled that the 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 two instances this year, 6 taxpayers claimed they had prepared Form 2553 but the IRS had no record of them filing the election. In both cases, the IRS granted the taxpayers relief under Sec. 1362(b)(5).
Practice tip: Tax practitioners should be aware that if past experience is any guide, going to court on this issue will not resolve the issue on a taxpayer-friendly basis.
In some situations an entity is formed as either a limited liability company (LLC) or a limited liability partnership (LLP) but wishes to be treated as an S corporation. In the past the entity had to file both Form 8832, Entity Classification Election, and Form 2553. However, for elections after July 20, 2004, 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 that makes a timely and valid election to be treated as an S corporation on Form 2553 will be deemed to have elected to be classified as an association taxable as a corporation. Even though Form 8832 does not need to be filed when the election is made, the corporation must attach a copy to its first tax return when filed.
Nonetheless, there were still several instances 7 in which the entity was required to file Form 8832, electing to be treated as a corporation, and then file Form 2553 to be taxed as an S corporation. However, in cases where the entity failed to file either of the elections, the IRS granted those entities relief and allowed S status from inception, as long as both forms were filed within 60 days of the ruling. It should be noted that the number of rulings on this issue should also be drastically reduced in the future.
Who signs Form 2553: 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. This election should be sent by certified mail (return receipt requested), registered mail, or a preapproved private delivery service (e.g., FedEx, DHL, or UPS). This year there were several situations in which the corporation did not obtain consent to make the S election from the appropriate shareholders.
In one ruling this year, 8 the company filed Form 2553 to be treated as an S corporation under Sec. 1361. The Form 2553 was correctly completed except that two of its shareholders did not consent to the S corporation election. At the time of the election, the co-executors for an estate failed to consent on behalf of the estate. In addition, the current income beneficiary of a QSST failed to consent to the company’s S corporation election. The IRS concluded that the company’s S corporation election was invalid under Sec. 1362(a)(2) because the estate and the income beneficiary failed to consent to the company’s S corporation election. 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.
In another instance, 9 a corporation tried to elect to be treated as an S corporation but failed to obtain consent from one of its shareholders as required. That omission meant that the S corporation election was invalid. When the corporation discovered the ineffectiveness of the election, it sought relief under Sec. 1362(f). The IRS concluded that the ineffective 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 original date of the election.
In Letter Ruling 201017038, 10 a corporation elected to be treated as an S corporation effective on date 1. Prior to that date, shares of the company were transferred to a qualified employee stock ownership plan (ESOP). The corporation had someone sign the Form 2553 for the ESOP; however, that person might not have had proper authority to do so. As a result of the failure of the proper party to sign the consent for the S corporation election, the S election might have been ineffective. In addition, after the corporation made the election, stock in the corporation was transferred to an ineligible shareholder, causing the corporation to no longer be eligible to be an S corporation. The IRS concluded that if the original election was invalid, the ineffective election was inadvertent. Therefore, the corporation would be treated as an S corporation from date 1 until it transferred the stock to the ineligible shareholder.
In another situation, 11 the shareholders of an S corporation engaged in several transactions that were intended to result in A and B owning all the outstanding shares of the S corporation. After the transfers, the only remaining shareholders of the corporation were A, B, and Estate. A stock assignment provided for the transfer of Estate’s shares to A for cash. However, the administrator of Estate did not execute the agreement. A and B signed Form 2553 based on their belief that they were the only two shareholders. The administrator of Estate did not sign the Form 2553. On a later date, the Estate administrator executed the assignment of the stock from Estate to A. The IRS concluded that the S election was ineffective because it was not signed by all of the shareholders but that the ineffectiveness was inadvertent. Therefore, the IRS would treat the entity as continuing to be an S corporation.
Finally, an entity elected to be treated as an S corporation. 12 However, due to a clerical error on the entity’s share register, the required consent for the election was not sought or obtained from one of its shareholders. As a result, the election was ineffective. The IRS concluded that the entity’s election to be treated as an S corporation was ineffective. However, it also concluded that the ineffective election constituted an inadvertent ineffective election under Sec. 1362(f).
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. In addition, there are restrictions on who can 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, defined as equal rights to distributions and liquidations (but not voting rights). Under the facts of Letter Ruling 201030018, 13 when a corporation elected S status it had two classes of stock with disparate preemptive rights. The corporation also had C corporation accumulated earnings and profits (AE&P). For each of the next three consecutive years, the corporation had passive investment income exceeding 25% of annual gross receipts. Thus, even if the S election had been valid, it would have terminated in year 4 under Sec. 1362(d)(3). Subsequently, the corporation amended its articles to eliminate the second class of stock. Then, realizing that its S election had terminated because of AE&P and excess passive investment income, the corporation made an election under Sec. 1368(e)(3)(A) to first treat distributions as dividends paid out of AE&P rather than the accumulated adjustments account and thus eliminate the AE&P. Claiming that the revocation of its S election was inadvertent, the corporation sought relief under Sec. 1362(f), which the IRS granted.
Practice tip: Tax advisers should be aware that several tax planning ideas arise out of this letter ruling fact pattern. The tax law allows a consent dividend 14 mechanism when the Sec. 1368(e)(3) election is in effect. This would allow a cash-strapped entity to solve its passive income problems by deeming a distribution and simultaneous capital contribution. This technique may also help increase the Sec. 1366(d) basis for losses as well as create 15% qualified dividend income and a potential corresponding 35% loss deduction.
Likewise, in Letter Ruling 200949030, 15 a state corporation converted to a state limited partnership. It filed Form 8832 electing to be treated as an association taxable as a corporation and Form 2553 to elect to be an S corporation, but at the time it had an ineligible shareholder. Furthermore, the conversion of the corporation to a state partnership with both general and limited partnership interests might have created a second class of stock. The corporation and its owners represented that they had intended the entity to be treated as an S corporation. The IRS concluded that the S election was an inadvertent invalid election within the meaning of Sec. 1362(f). In addition, if the corporation’s conversion from a state corporation to a state partnership with both general and limited interests created a second class of stock, which would have terminated the S election, the termination was also inadvertent.
In Letter Ruling 201017019, 16 the stockholder’s agreement of an S corporation required the company to make payments to its shareholders based on each shareholder’s pro-rata share of the company’s taxable income for a given tax period to ensure that the shareholders had sufficient funds to pay income taxes on their respective shares of the company’s income. A discretionary payment provision was originally intended to allow the company to assist its shareholders in paying additional tax liability resulting from an increase in the corporation’s taxable income or a decrease in the company’s creditable foreign taxes. The company sought to amend the discretionary payment provision to cover other post-filing adjustments to the company’s tax returns. In all cases, the amount of any distribution pursuant to the amended discretionary payment provision was required to be allocated proportionately among shareholders by reference to their respective interests in the company’s taxable income or loss for the relevant period. The IRS concluded that the discretionary payment provision and distributions made pursuant to it did not cause the company to have more than one class of stock.
In another ruling, 17 an S corporation subsequently discovered that due to some inadequate advice it received, some of its shareholders suffered financial damages. These shareholders sought compensation for the damages sustained. The IRS concluded that the damage payments to the shareholders did not create a second class of stock and would not jeopardize the entity’s S corporation status.
In Letter Ruling 201015017, 18 the S corporation had three classes of stock. Of the three, classes 1 and 2 were transferable to third parties subject to some conditions set out in a written agreement. Class 3 stock was the subject of a stock option plan (SOP), which was intended not to qualify as an incentive stock option plan. The S corporation later adopted a restricted stock plan (RSP) under which certain key employees and independent directors might receive awards of class 3 stock. The S corporation stated that neither the agreement, the SOP, nor the RSP were created to circumvent the one class of stock requirement. The IRS ruled that the agreement, SOP, and RSP did not cause the corporation to have more than one class of stock for purposes of Sec. 1361.
In another situation, 19 A and B were the only shareholders of an S corporation until they sold all their stock to an unrelated corporation. Prior to the sale, the corporation had made disproportionate distributions to A and B during the course of operations. The corporation represented that each share had identical rights to liquidation proceeds and distributions and that no other binding agreements existed that varied those rights. A corrective distribution and a payment by A to B were completed, resulting in distributions proportionate to A’s and B’s respective interests in the corporation since its inception as an S corporation. The IRS concluded that the disproportionate distributions the corporation made to A and B did not create a second class of stock. Thus, the S election did not terminate under Sec. 1362.
A similar situation occurred in Letter Ruling 200944018, 20 where an S corporation made disproportionate distributions to its shareholders. The company later discovered the error and rectified it by making the necessary corrective distributions. It then sought rulings that any termination of its S status was inadvertent within the meaning of Sec. 1362(f). The IRS agreed and so ruled. Thus, the company would be treated as continuing to be an S corporation from the original election, provided that its election had not otherwise terminated.
In Letter Ruling 201006010, 21 subsequent to a company’s making an S election, the company issued stock warrants in connection with debt-financing transactions. The issuance of the warrants might have terminated the S election. When the corporation discovered that the warrants might be deemed as a second class of stock, it immediately sought legal advice to rectify the situation. The IRS concluded that the S election may have terminated because the corporation might have had more than one class of stock. However, if the S election was terminated, such a termination was inadvertent within the meaning of Sec. 1362(f). Consequently, the IRS ruled that the company would be treated as continuing to be an S corporation until it was intentionally terminated several years later.
In another situation, 22 an S corporation elected to treat each of its subsidiaries as a QSub. On the date of the S corporation election, it was unaware that its two classes of stock might have prevented it from being an S corporation. Upon discovering the possibility of an invalid election, steps were taken immediately to qualify it as a small business corporation. The IRS concluded that the election to be treated as an S corporation might have been invalid and that if the election was invalid, it constituted an inadvertent invalid election within the meaning of Sec. 1362(f).
In Letter Ruling 201010021, 23 a company elected S status. At that time it had only a single class of outstanding stock, all the shares of which had identical rights to distribution and liquidation. However, the company made disproportionate distributions to its shareholders. It later discovered the error and undertook to cure those errors through corrective distributions and by requiring shareholders who had received excess distributions to repay them with interest. It then sought a ruling that any termination of its S status was inadvertent, which the IRS granted, conditioned on the company making all corrective distributions within 90 days of the date of the ruling.
A subsidiary that wants to be treated as an S corporation must be wholly owned by a parent S corporation, and a QSub election must be properly filed. The election should be filed on Form 8869, Qualified Subchapter S Subsidiary Election, by the fifteenth day of the third month after the effective date. In the past, numerous ruling requests involved a late filing of this election.
The IRS can now waive inadvertently invalid QSub elections and terminations that occur after 2004 if the conditions of Sec. 1362(f) are met. This is consistent with Rev. Proc. 2004-49, 24 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, there were still requests for rulings 25 seeking relief for the 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 60 days from the ruling date to make the election.
Earnings and Profits
If an S corporation has subchapter C AE&P, it will be subject to a tax under Sec. 1375 on its excess net passive investment income if its total passive investment income exceeds 25% of its gross receipts. Most of the rulings in this area have dealt with whether rental real estate activities were active or passive in nature for purposes of the tax. Under Regs. Sec. 1.1362-2(c)(5)(ii)(B), rents received by a corporation are treated as from an active trade or business of renting property only if, based on all the facts and circumstances, the corporation provides significant services or incurs substantial costs in the rental business.
Since the issuance of the regulations, the IRS has been lenient in its definition of passive income; as a result, the number of ruling requests is down significantly. This year, income from commercial and residential rentals was deemed to be active income. 26 In these rulings, the S corporation provided various services to the tenants, including utilities and maintenance for common areas, landscaping, garbage removal, and security. In addition, the S corporation handled leasing and administrative functions, including billing, rent collection, finding new tenants, and negotiating leases.
In Letter Ruling 201029015, 27 a corporation expected to have AE&P from prior years when it made its S and QSub elections. The QSub owned residential real estate leased to tenants. More than 25% of the combined gross receipts of the corporation and the QSub would be derived from those rentals. The corporation, through its own employees and through its agents and their employees, provided various services in connection with the leasing of the QSub’s properties, including maintenance, repair, heating and ventilation, and landscaping. Given those facts, the IRS concluded that such rental income was not passive investment income. However, the reader should note that the ruling pointed out that Sec. 1362’s passive investment income rules were completely independent of the passive activity rules in Sec. 469 and that unless an exception under Sec. 469 was applicable under the facts, the rental activity at issue would remain passive for purposes of Sec. 469.
In another situation, 28 an S corporation was in the business of operating, managing, and leasing commercial real estate used as parking facilities. It owned some of the facilities through qualified subsidiaries and others through third-party partnerships. In the latter cases, the S corporation managed the partnership and the property for a management fee. The corporation’s employees performed work for the properties. The corporation also used a third-party management entity to provide labor and field management, including accounting, auditing, billing and collections, common area maintenance, janitorial services, landscaping, maintenance and repair, elevator maintenance and repair, provision of utilities, pest control, and provision of security services. Given those arrangements, the IRS applied a facts-and-circumstances test and concluded that the receipts at issue were not passive investment income.
In yet another instance, 29 a corporation that intended to elect S status derived income from leasing space in a shopping center that it owned and operated, and directly performed, through either employees or contractors, necessary services including inspection, repairs, and maintenance of the physical premises. The IRS ruled that, given the facts and circumstances, it was reasonable to conclude that the corporation provided significant services or incurred substantial costs in its rental business. Because the rents at issue were derived in the active trade or business of renting property, they did not constitute passive investment income.
In a slightly different fact pattern, 30 an S corporation engaged in two lines of business: convenience stores and rental real estate. In the first line of business, the company was a petroleum marketer supplying its stores and also selling products to residential and commercial customers. In the second business, it owned and managed rental properties for which it supplied, through its own employees, lease negotiation and services for maintenance and upkeep of the properties. The company requested a ruling that the rental income received by both lines of business was not passive investment income. The IRS concluded that the S corporation was supplying significant services or that it was incurring substantial costs in connection with the rental businesses, so the rental income was not passive investment income.
Usually the problem with passive investment income is rental income. However, in Chief Counsel Advice (CCA) 201030024, 31 the income at issue was dividends. An S corporation with accumulated C corporation earnings and profits owned 100% of several controlled foreign corporations (CFCs). 32 The S corporation received significant amounts of dividend income from the CFCs. Under Sec. 1362(d)(3)(C)(iv), dividend income from a C corporation meeting the requirements of Sec. 1504(a)(2) is not considered passive investment income. Thus, the question that arose was whether a CFC would be considered similar to a qualified consolidated C corporation, albeit a foreign corporation. The IRS ruled that the CFCs would be considered an affiliated C corporation under Sec. 1362, so the dividends the S corporation received from them would not be considered passive investment income.
Sec. 1362(d)(3) Terminations
Under Sec. 1362(d)(3), a corporation may also 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 has issued several rulings on termination of S status.
In one situation, 33 when the corporation made its S election, its accountants did not know that it had AE&P. For each of the next three years, the corporation had passive investment income in excess of 25% of its yearly gross receipts. During the fourth year, the corporation engaged a new accountant who determined that the corporation had AE&P. The company planned to elect pursuant to Regs. Sec. 1.1368-1(f)(3) to distribute all its AE&P to its shareholders through a deemed dividend. The IRS ruled that the S election terminated because the corporation had AE&P at the close of each of three consecutive tax years and gross receipts for each of those tax years more than 25% of which were passive investment income. However, that termination was inadvertent, so the IRS would treat the corporation as continuing to be an S corporation.
In a similar situation, 34 a corporation that elected to be an S corporation had earnings and profits and gross receipts of which more than 25% was passive investment income for the first three years it was an S corporation. As a result, the S election terminated on the first day of the fourth year. A dividend was paid after the termination. The IRS concluded that the S election terminated under Sec. 1362(d)(3)(A) because the corporation had earnings and profits at the close of each of three consecutive tax years and had gross receipts for each of those tax years, more than 25% of which were passive investment income. However, that termination was an inadvertent termination.
Likewise, in Letter Ruling 200947001, 35 a corporation elected S status when it had AE&P due to its prior C corporation years. For each of the first three years, the S corporation had passive investment income exceeding 25% of its yearly gross receipts, so the S election terminated. In the fourth year, the corporation discovered the termination of its S election and distributed all its subchapter C earnings and profits to its shareholders. The IRS concluded that the termination of the S election was inadvertent; the corporation would be allowed to keep its S corporation status.
In another situation, 36 an S corporation with AE&P remaining from its years as a C corporation sold its operations to a third party. As agreed, the S corporation maintained its corporate existence and maintained the note and cash reserves in an escrow account in its name. However, the corporation inadvertently terminated its S election because in the next three years the only earnings it had were from interest income on the note and escrow account holdings predating its sale of business operations. It also still had AE&P. When the corporation realized that its S corporation status had terminated, it sought relief under Sec. 1362(f), which the IRS granted.
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 Letter Ruling 201028024, 37 after a corporation made an S election, an ineligible shareholder became a shareholder, and the termination of the S election was discovered. Steps were taken so that the corporation could qualify as an S corporation. The IRS concluded that the S election terminated when the ineligible entity became a shareholder but that this termination constituted an inadvertent termination.
In another instance, 38 S corporation stock was transferred to a corporation owned by an individual who had represented that the corporation was an eligible S corporation shareholder although it was not one. The transfer thus terminated the S election. When it discovered the ineligibility, the S corporation sought a ruling that the termination was inadvertent and that it had continued to be an S corp. The IRS held that the transfer to the ineligible shareholder had terminated the S election but that the termination was inadvertent within the meaning of Sec. 1362(f) and that the corporation would be entitled to continue to be treated as an S corporation if the ineligible corporation transferred its stock to its individual owner.
In Letter Ruling 201026006, 39 the original shareholders of an S corporation executed a shareholders’ agreement providing inter alia that a shareholder desiring to transfer shares had to obtain the prior consent of other shareholders, that the proposed transferee had to agree to become a party to the agreement, and that no transfer that would trigger termination of the S election was permissible. Nonetheless, a shareholder attempted to transfer some of his shares to an ineligible shareholder. A court ruling was later obtained holding that the attempted transfer was null and void and that the original shareholder remained the owner of the shares. The IRS further ruled that the transfer was void under state law; thus, the corporation’s S election did not terminate on the date of the attempted transfer.
Likewise, in Letter Ruling 201017009, 40 S corporation stock was transferred to an ineligible S shareholder, thereby terminating the company’s S status. After the ineligibility was discovered, the company took steps to address its S status, including requesting that the IRS rule that the termination of its S election was inadvertent and that it had continued to be an S corporation. In making that request, it represented that the circumstances resulting in the termination of the company’s S status were inadvertent and were not motivated by tax avoidance. The IRS held that the company’s S status in fact would have been terminated by the presence of an ineligible shareholder but that the termination was inadvertent.
In another situation, 41 S shareholders transferred shares to A, an ineligible shareholder. Neither the corporation nor the shareholders were aware that the transfer of stock to A would cause the S election to be terminated. The IRS concluded that the S election was terminated because A was an ineligible shareholder but that the termination constituted an inadvertent termination and the corporation would be treated as an S corporation, provided that its election was otherwise valid and had not otherwise terminated.
In Letter Ruling 201027001, 42 an S corporation transferred shares to a nonresident alien, an ineligible S corporation shareholder. Upon discovery of the error, the corporation promptly took remedial action and redeemed all the shares it had issued to the nonresident alien. The IRS concluded that the S corporation election terminated when it issued stock to an ineligible shareholder. However, this termination was inadvertent. Thus, the IRS would treat the company as an S corporation, provided that the election was valid and was not otherwise terminated. The eligible shareholders of the S corporation would be treated as directly owning a pro-rata portion of the shares of the corporation that were held by the nonresident alien, in addition to any other shares of the corporation that they held during that period.
A partnership or LLC is an ineligible S corporation shareholder. In Letter Ruling 201016025, 43 S stock was transferred to LLC, which was owned by A, B, C, D, and E and was an ineligible shareholder. When LLC’s ineligibility was discovered, it distributed to B, C, D, and E their pro-rata shares of the S stock. LLC, which continued to hold A’s shares, became a disregarded entity owned solely by A, a qualified shareholder. The IRS held that the S election would have been terminated by the presence of an ineligible shareholder but that the termination was inadvertent and that the company would continue to be treated as an S corporation throughout the period, notwithstanding the temporary existence of the ineligible shareholder.
In two situations, 44 an S corporation’s election was inadvertently terminated when a partnership became the owner of the S stock. The owners of the partnership entered into an agreement to transfer the stock ownership to one owner, which resulted in the partnership’s federal tax classification changing from a partnership to an entity disregarded from its owner. The IRS concluded that the termination of the S election was inadvertent, and the corporation continued to be treated as an S corporation.
The general rule is that an IRA cannot be an S shareholder. This year in Taproot Administrative Services, 45 the Tax Court determined that a Roth IRA was not an eligible S corporation shareholder, so the corporation’s S election had terminated. In this case, the sole shareholder was a custodial Roth IRA account. The taxpayer argued that the Roth IRA was an eligible shareholder. The court noted that regulations did not explicitly prohibit a traditional or Roth IRA from owning S corporation stock. However, the judge relied on Rev. Rul. 92-73, 46 in which the IRS concluded that a trust that qualifies as an IRA is not a permitted shareholder. He also noted that the IRS had applied this rule consistently to all IRAs. The court also noted that there was no indication that Congress ever intended to allow IRAs to be S corporation shareholders. Thus, both traditional IRAs (which the courts have ruled on in the past) and Roth IRAs are ineligible S corporation shareholders.
Certain trusts may own S stock. However, there are strict rules that the trusts must follow to continue as eligible shareholders. Therefore, an S corporation and its tax advisers must constantly monitor trust shareholders’ elections, trust agreements, and their subsequent modifications for compliance with S eligibility rules. This year the IRS ruled in several situations on trusts as S shareholders.
In the first ruling, 47 after X elected to be an S corporation, two of its four shareholders transferred shares to a trust, which was not a qualified shareholder. Consequently, X’s S election terminated. The IRS concluded that the termination of the S corporation election was inadvertent under Sec. 1362(f), and X would be treated as continuing to be an S corporation. The shareholders who transferred the shares to the trust would be treated as the shareholders of the corporation.
In another ruling, 48 a shareholder in an S corporation sold shares to Trust1 and Trust2, both of which were wholly owned grantor trusts and permissible S corporation shareholders. However, the shares held by the trusts were later transferred to a large group of trusts, each of which qualified for classification as a qualified subchapter S trust (QSST), except that the beneficiary of each failed to make the election. Thus, the company’s S election technically terminated. When the omission was discovered, the company sought relief on claims that the termination was inadvertent and that it was not motivated by either tax avoidance or retroactive tax planning. The IRS granted that relief, provided that proper QSST elections for each trust were filed within 60 days.
In two rulings this year, 49 the stock was transferred to a testamentary trust under the terms of the shareholder’s will. Under the terms of the trust, the sole beneficiary was the shareholder’s spouse. The trust was eligible to be a QSST so that it could hold the stock for more than two years, but the beneficiary failed to make the QSST election. The IRS ruled that the termination was inadvertent, contingent upon the spouse’s filing a QSST election.
In another situation, 50 individuals A and B transferred shares of an S corporation into Trust1, which provided that some of those shares were to be held in a separate trust (Trust2) for B’s benefit. Trust2 was in fact treated as if owned by B. At B’s death, the shares were to be held by Trust3, which was intended to qualify as a QSST. A was Trust3’s sole beneficiary. When A failed to file a timely QSST election for Trust3, the S election was terminated. After A died, the failure to file the election and the resulting termination were discovered. The S corporation sought relief in the form of a ruling that the termination was inadvertent, which the IRS granted.
In a similar situation, 51 an S corporation shareholder established a revocable trust treated as a wholly owned grantor trust to which he transferred the S corporation stock. Trust1 ceased to be a grantor trust on the grantor’s death, but it continued to qualify as an S corporation shareholder beginning on the day of the grantor’s death and ending when the stock held by Trust1 was transferred to Trust2. However, because Trust2’s trustees failed to make an ESBT election for Trust2, the transfer of the stock to Trust2 triggered the termination of the taxpayer’s S corporation election. In requesting relief, the taxpayer represented that Trust2 was qualified to be treated as an ESBT and that the circumstances resulting in termination were inadvertent within the meaning of Sec. 1362(f). The IRS agreed.
Other Trust Issues
Election requirements: Another problem encountered by trusts is that for both a QSST and an ESBT, a separate election must be made for the trust to qualify as an eligible S shareholder. Often this election is filed incorrectly, is not timely filed, or the wrong party signs the election, and an inadvertent termination ruling is needed. This year there were numerous instances 52 in which a trust was intended to be treated as either 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 to make the election and granted a 60-day extension from the ruling date to make the election. In each of these cases, the ruling was contingent on the corporation’s being treated as an S corporation from the time the trust received the stock until the present. Therefore, all shareholders had to include their pro-rata share of the corporation’s income, make any needed adjustments to basis, and take into account any distributions made by the S corporation. If necessary, the corporation and its shareholders were required to file amended tax returns.
In Letter Ruling 200952037, 53 at the time of the company’s S election, shares of its stock were held in a trust. The trust made an election to be treated as a QSST but did not satisfy the QSST requirements. The S corporation represented that the trust qualified to be treated as an ESBT, but no ESBT election was ever made. As such, the trust was an ineligible shareholder, and the company’s S election was never valid. The IRS concluded that the company’s S election was not effective because the trust was an ineligible shareholder but said that the circumstances resulting in such ineffectiveness were inadvertent and that the entire corporation was to be treated as an S corporation, assuming the correct election was made.
In another instance, 54 S stock was transferred to a trust, then an eligible S corporation shareholder. After the transfer, the trust ceased to be a qualified trust for purposes of Sec. 1361. Thus, the company’s S election terminated. When the company discovered the termination, it commenced to treat the trust as a QSST, and the income beneficiary of the trust reported his share of income consistent with the trust’s treatment as a QSST. But the trust was not a QSST because the beneficiary failed to file a QSST election and because the trust could distribute income and corpus to the beneficiary’s dependents. Because the beneficiary had no dependents, he obtained a trust modification so that during his life he was the trust’s only income and corpus distributee. Given these facts, the IRS ruled that the termination was inadvertent but conditioned the ruling on the timely filing of a QSST election.
Likewise, in Letter Ruling 201002007, 55 when a corporation made an S election, each of two grantor trusts (trust A and a spousal trust) owned 50% of its stock. When A’s grantor died, trust B was established and the stock held in A was transferred to it. The spouse was B’s income beneficiary. B met all the criteria for QSST status, but the spouse failed to elect such status. That meant B was not an eligible S corporation shareholder, and its ownership of S stock terminated the S election. The IRS held that the S election terminated as a result of the spouse’s failure to timely make the required election but that the termination was inadvertent.
In a similar situation, 56 all the shares of an S corporation were transferred to trust A, a wholly owned grantor trust qualified to hold shares of an S corporation. A’s assets, including all the S stock, were later transferred to trust B. B was eligible to be a QSST, but due to inadvertence, no QSST election was ever filed for B. B did not otherwise qualify as an eligible shareholder of an S corporation. Thus, the company’s S election terminated as of this transfer. As in the other rulings, the IRS concluded that the company’s S election was terminated when stock in the company was transferred to B but that the termination was inadvertent. A similar ruling can also be found in Letter Ruling 200946015. 57
In a different situation, 58 an S corporation shareholder transferred stock to three trusts that did not qualify as QSSTs. The S corporation represented that the assets of the three trusts, including their shares in the S corporation, would be transferred to three other trusts upon the grant of relief under Sec. 1362(f). Under the terms of the trust instruments, the new trusts qualified as QSSTs, and QSST elections for these trusts, which already held S corporation stock, were timely made. The IRS so ruled.
When a trust that was an invalid S corporation shareholder became a shareholder of an S corporation, no election was made to treat the trust as an ESBT. 59 As a result, the S corporation election was invalid. The trust sold its shares in the S corporation to a wholly owned grantor trust that was a valid S corporation shareholder. The S corporation represented that the circumstances resulting in its invalid S corporation election were inadvertent and not motivated by tax avoidance or retroactive tax planning. It further represented that it filed returns consistent with its status as an S corporation. The IRS concluded that the S corporation election was not effective because the trust was not an eligible shareholder. It also concluded that the ineffective S election was inadvertent and that it would treat the entity as an S corporation, provided that the election was otherwise valid.
In another instance, 60 an S corporation’s shares were transferred to trust A, a revocable trust treated as a wholly owned grantor trust. Trusts B, C, D, and E were later created and each received S stock. However, trusts B, C, D, and E failed to elect ESBT status, thus terminating the company’s S election. Thereafter, A’s grantor died, terminating A’s grantor trust status. Had the company’s S status not already been terminated when B, C, D, and E failed to file ESBT elections, A’s failure to file an ESBT election within two years of its grantor’s death would have resulted in termination. When the termination of the company’s status was discovered, it sought relief in the form of a ruling that the termination was inadvertent. The IRS agreed and ruled that the company would continue to be treated as an S corporation, provided that all five trusts filed valid ESBT elections reflecting the appropriate effective dates. The IRS came to the same conclusion in Letter Ruling 201015001 61 in a situation with similar facts.
Estates and Valuation of Transferred Interest
In August 2010, the Tax Court ruled in Estate of Jensen 62 that a C corporation with appreciated assets was eligible for a full built-in gain tax discount relative to land and a summer camp business. If an S corporation had Sec. 1374 built-in gain tax potential and gifted the stock, or on a shareholder’s death needed to value the stock, this case as well as a long line of similarly held cases 63 would provide ammunition for decreasing the stock’s value by the full amount of the potential built-in gain tax.
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, 64 an entity terminated its S corporation election by creating a second class of stock that facilitated the creation of an ESOP. Shareholders then sold a portion of their stock to the ESOP. No Sec. 1042 election was made at that time. The IRS allowed the entity’s request for permission to reelect S corporation status before the expiration of the five-year statutory waiting period. The IRS noted that the entity terminated its S corporation status by creating two classes of stock but because more than 50% of the stock was owned by shareholders who did not own stock on the date of the termination the corporation was allowed to reelect S status. It is interesting that the results in this situation were opposite those of a very similar situation in a 2008 ruling. 65 In that case, there was a 100% change in ownership, but the IRS denied the corporation’s request to reelect S status. In that situation the entity terminated its S corporation status by creating two classes of stock. Then two individual shareholders sold their stock to the ESOP and made a Sec. 1042 election. Only C corporation shareholders can sell their stock to an ESOP and defer the gain by electing Sec. 1042 treatment for a qualified stock sale. The election of Sec. 1042 treatment by two shareholders with respect to their sale of the entity’s stock to the ESOP precluded Sec. 1362(g) relief without regard to the redemption of the entity’s stock causing a more than 50% ownership change as described under Regs. Sec. 1.1362-5(a).
1 T.D. 9498 and 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 201028028 (7/16/10), 201025023 (6/25/10), 201014039 (4/9/10), 201013021 (4/2/10), and 200949033 (12/4/09).
5 IRS Letter Rulings 201025042 (6/25/10), 201029001 (7/23/10), 201026031 (7/2/10), and 201016050 (4/23/10).
6 IRS Letter Rulings 201027037 (7/9/10) and 201004023 (1/29/10).
7 IRS Letter Rulings 201029010 (7/23/10), 201016010 (4/23/10), 201010011 (3/12/10), 201004002 (1/29/10), and 200947023 (11/20/09).
8 IRS Letter Ruling 201019009 (5/14/10).
9 IRS Letter Ruling 201025002 (6/25/10).
10 IRS Letter Ruling 201017038 (4/30/10).
11 IRS Letter Ruling 201030002 (7/30/10).
12 IRS Letter Ruling 201017030 (4/30/10).
13 IRS Letter Ruling 201030018 (7/30/10).
14 Regs. Sec. 1.1368-1(f)(3).
15 IRS Letter Ruling 200949030 (12/4/09).
16 IRS Letter Ruling 201017019 (4/30/10).
17 IRS Letter Ruling 201016040 (4/23/10).
18 IRS Letter Ruling 201015017 (4/16/10).
19 IRS Letter Ruling 201006026 (2/12/10).
20 IRS Letter Ruling 200944018 (10/30/09).
21 IRS Letter Ruling 201006010 (2/12/10).
22 IRS Letter Ruling 200945008 (11/6/09).
23 IRS Letter Ruling 201010021 (3/12/10).
24 Rev. Proc. 2004-49, 2004-2 C.B. 210.
25 See, e.g., IRS Letter Rulings 201031002 (8/6/10), 201027033 (7/9/10), 201016013 (4/23/10), and 200947008 (11/20/09).
26 See, e.g., IRS Letter Rulings 201025040 (6/25/10) and 201005025 (2/5/10).
27 IRS Letter Ruling 201029015 (7/23/10).
28 IRS Letter Ruling 201027022 (7/9/10).
29 IRS Letter Ruling 200946032 (11/13/09).
30 IRS Letter Ruling 200946009 (11/13/09).
31 CCA 201030024 (7/30/10).
32 These entities could not be QSubs because they were foreign corporations, which would violate the rules of Sec. 1361(b)(3)(B).
33 IRS Letter Ruling 201031030 (8/6/10).
34 IRS Letter Ruling 200952005 (12/24/09).
35 IRS Letter Ruling 200947001 (11/20/09).
36 IRS Letter Ruling 201025033 (6/25/10).
37 IRS Letter Ruling 201028024 (7/16/10).
38 IRS Letter Ruling 201027014 (7/9/10).
39 IRS Letter Ruling 201026006 (7/2/10).
40 IRS Letter Ruling 201017009 (4/30/10).
41 IRS Letter Ruling 201017036 (4/30/10).
42 IRS Letter Ruling 201027001 (7/9/10).
43 IRS Letter Ruling 201016025 (4/23/10).
44 IRS Letter Rulings 201014035 (4/9/10) and 200953016 (1/4/10).
45 Taproot Admin. Servs., Inc., 133 T.C. No. 9 (2009).
46 Rev. Rul. 92-73, 1992-2 C.B. 224.
47 IRS Letter Ruling 200952015 (12/24/09).
48 IRS Letter Ruling 201020007 (5/21/10).
49 IRS Letter Rulings 201001010 (1/8/10) and 201001012 (1/8/10).
50 IRS Letter Ruling 200942019 (10/16/09).
51 IRS Letter Ruling 201011005 (3/19/10).
52 See, e.g., IRS Letter Rulings 201029005 (7/23/10), 201006017 (2/12/10), 201017041 (4/30/10), 201003002 (1/22/10), and 200946008 (11/13/09).
53 IRS Letter Ruling 200952037 (12/24/09).
54 IRS Letter Ruling 201016016 (4/23/10).
55 IRS Letter Ruling 201002007 (1/15/10).
56 IRS Letter Ruling 200949032 (12/4/09).
57 IRS Letter Ruling 200946015 (11/13/09).
58 IRS Letter Ruling 200945023 (11/6/09).
59 IRS Letter Ruling 201010007 (3/12/10).
60 IRS Letter Ruling 201002003 (1/15/10).
61 IRS Letter Ruling 201015001 (4/16/10).
62 Estate of Jensen, T.C. Memo. 2010-182.
63 See Estate of Litchfield, T.C. Memo. 2009-21, and Mandelbaum, T.C. Memo. 1995-255, both dealing explicitly with S corporations; and Eisenberg, 155 F.3d 50 (2d Cir. 1998); Estate of Davis, 110 T.C. 530 (1998); Estate of Jelke, 507 F.3d 1317 (11th Cir. 2007); and Estate of Dunn, 301 F.3d 339 (5th Cir. 2002), dealing with C corporations’ built-in gains.
64 IRS Letter Ruling 201016036 (4/23/10).
65 IRS Letter Ruling 200851003 (12/19/08).
Hughlene Burton is an associate professor in the Department of Accounting at the University of North Carolina–Charlotte in Charlotte, NC, and is chair of the AICPA Tax Division’s Partnership Taxation Technical Resource Panel. Stewart Karlinsky is a professor emeritus at San Jose State University in San Jose, CA, and a 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.