Obtaining a Waiver of an Invalid S Election

Editor: Albert B. Ellentuck, Esq.

The IRS has authority to waive the effect of an invalid election. When an S corporation election is ineffective because the corporation failed to qualify as a small business corporation, or obtain shareholder consents, the corporation will be treated as an S corporation during the period specified by the IRS if all of the following conditions are met (Sec. 1362(f)):

1. The IRS determines that the circumstances resulting in the ineffective election were inadvertent.
2. Within a reasonable period after discovering the circumstances causing the invalidity, steps are taken to qualify the corporation as a small business corporation or to obtain the requisite shareholder consents (including elections for QSSTs and ESBTs).
3. During the period that the S election was ineffective, the corporation and each shareholder agree to adjustments required by the IRS pertaining to that period.

The IRS has provided the following ways to obtain relief from invalid elections:

1. Extension of time to obtain consents under Regs. Sec. 1.1362-6. If the S election is invalid because shareholder consents were omitted, Regs. Sec. 1.1362-6(b)(3)(iii) provides that the S corporation can request an extension of time to furnish the consents. No user fee is required.
2. Relief from late election under Rev. Proc. 2007-62. If the election is late, relief is provided under Rev. Proc. 2007-62, which allows the S corporation to file a late Form 2553, Election by a Small Business Corporation, along with the corporation’s first S corporation income tax return. Under Rev. Proc. 2007-62, a corporation can obtain relief from filing a late S election if a request for relief is filed no later than six months after the original due date (excluding extensions) of the Form 1120S, U.S. Income Tax Return for an S Corporation, for the year the election was first intended. The S corporation must show reasonable cause why the election was not filed in a timely manner. No user fee is required.
3. Relief from late election under Rev. Proc. 2003-43. If the S election is late, relief is provided under Rev. Proc. 2003-43, which allows the S corporation to file Form 2553 even though the due date has passed. Under Rev. Proc. 2003-43, a corporation can obtain relief for failing to file an S election if a request for relief is filed within 18 (or, in certain cases, 24) months of the original due date of the S election. The S corporation must show reasonable cause why the election was not filed in a timely manner. No user fee is required.
4. Relief from late election under Rev. Proc. 97-48. Late S elections are also permitted under Rev. Proc. 97-48. The corporation must have filed S corporation tax returns (Form 1120S), and the shareholders must have reported their income consistent with S status for the tax year in which the S election should have been made and for all later years. No user fee is required.
5. Letter ruling. The S corporation can request relief from an invalid election by obtaining a letter ruling (Announcement 97-4; see also Rev. Proc. 2003-43). A user fee must accompany the request for a letter ruling.

The IRS has seemingly been generous in waiving invalid elections (as it has with granting relief from inadvertent terminations). In numerous letter rulings, the IRS has ruled that the corporation had reasonable cause for not filing its election on time and allowed the S election to become effective on the date requested. For example, invalid election relief was granted when the taxpayer relied on other parties to file the Form 2553 (IRS Letter Rulings 9809033, 200239015, and 200302025); when the corporation had an ineligible shareholder on the date the election was to become effective (IRS Letter Rulings 9716015 and 9717019); when employees inadvertently failed to mail the Form 2553 (IRS Letter Rulings 9719009 and 9720019); and even when no reason was given for the late filing (IRS Letter Rulings 200303039, 200303049, and 201048027).

Relief Under Rev. Proc. 2007-62

Rev. Proc. 2007-62 allows eligible small business corporations to request relief from a late S corporation election by filing Form 2553 with the S corporation’s first income tax return. The procedure is in lieu of the letter ruling process ordinarily used to obtain relief for late elections. Accordingly, no user fee is required. Rev. Proc. 2007-62 can be used to correct a late filed S election if the following requirements are met:

1. The corporation fails to qualify for its intended status as an S corporation on the first day that status was desired solely because of the failure to timely file an S election with the appropriate IRS Service Center.
2. The request for relief from the late election is filed no later than six months after the original due date (excluding extensions) of the Form 1120S for the year the election was first intended (i.e., its first Form 1120S).
3. The corporation has not yet filed its first Form 1120S.
4. The corporation has reasonable cause for its failure to make a timely election.
5. All taxpayers whose tax liability or tax returns would be affected by the election (including all shareholders of the S corporation) have reported consistently with the S corporation election on all affected returns for the year the election was intended and for any subsequent years. (This basically means that proper Schedules K-1 have been issued to the shareholders and they have reported the passthrough items on their tax returns as if a valid S election was in effect.)

Under Rev. Proc. 2007-62, the taxpayer attaches a completed Form 2553 to its first Form 1120S. Page 1 of Form 2553 includes a space for entering an explanation giving reasonable cause for the late election. Forms 1120S and 2553 must be filed no later than six months after the original due date (excluding extensions) of the S corporation’s first return.

When it is discovered that Form 2553 has not been timely filed, the planner must decide which revenue procedure is the most efficient under the circumstances. For example, Rev. Proc. 2007-62 provides that Form 2553 is to be filed together with the corporation’s first S return, Form 1120S. On the other hand, Rev. Proc. 2003-43 calls for the late Form 2553 to be mailed or otherwise delivered to the appropriate IRS Service Center. If the late S election is discovered several months before Form 1120S is due, it is advisable to use the Rev. Proc. 2003-43 procedures to correct the error.

Although the chances of the IRS granting relief are very good, approval is not automatic. So, filing under Rev. Proc. 2003-43 before the tax return is filed in order to verify the S election’s validity as soon as possible may be the best way to proceed. However, if Form 1120S is to be filed soon, sending Forms 1120S and 2553 together under Rev. Proc. 2007-62 may be the most efficient course to follow.

Relief Under Rev. Proc. 2003-43

Rev. Proc. 2003-43 relief for a late S election is available if the following requirements are met:

1. The corporation fails to qualify for its intended status as an S corporation on the first day that status was desired solely because of the failure to timely file an S election with the appropriate Service Center.
2. Less than 24 months have passed since the original due date of the S election.
3. The corporation has reasonable cause for its failure to make a timely election.
4. All taxpayers whose tax liability or tax returns would be affected by the election (including all shareholders of the S corporation) have reported consistently with the S corporation election on all affected returns for the year the election was intended, and for any subsequent years. (This basically means that proper Schedules K-1 have been issued to the shareholders and they have reported the passthrough items on their tax returns as if a valid S election was in effect.)

The deadline for filing for late S election relief depends on whether the corporation has filed a tax return (Form 1120S):

• If the corporation has not filed Form 1120S, the election Form 2553 must be filed under Rev. Proc. 2003-43 by the earlier of 18 months after the original due date for the S corporation election, or six months after the due date of Form 1120S (excluding extensions) for the first year the election was intended.
• If the corporation has filed Form 1120S for the first year in which the election was intended, the application for relief is filed under Rev. Proc. 2003-43 within 24 months of the original due date for the S corporation election. To qualify for relief, Form 1120S must have been filed within six months of the due date of Form 1120S (excluding extensions).

All taxpayers whose tax liability or tax returns would be affected by the election (including all shareholders of the S corporation) must have reported consistently with the S corporation election on all affected returns for the year the election was intended, and for any following years.

The application for relief under Rev. Proc. 2003-43 for a late S election is made by filing a properly completed Form 2553 with the Service Center where the original S election would have been filed.

Relief Under Rev. Proc. 97-48

Rev. Proc. 97-48 provides automatic relief for late S corporation elections. No user fee is required when relief is sought under this procedure. Rev. Proc. 97-48 applies if all of the following conditions are met:

1. The corporation fails to qualify as an S corporation solely because Form 2553 was not timely filed.
2. The corporation and all of its shareholders reported their income consistent with S corporation status for the year the S corporation election should have been made, and for every subsequent tax year, if any.
3. At least six months have elapsed since the corporation filed its tax return for the first year the corporation intended to be an S corporation.
4. Neither the corporation nor any of its shareholders has received notice from the IRS regarding its S corporation status within six months of when it timely filed Form 1120S for the first year.

Rev. Proc. 97-48 can preserve the S status of a corporation that did not timely file its S election, Form 2553. The procedure also applies to an S corporation that thought it had validly filed its election and has subsequently filed Form 1120S for several years. The procedure cannot be used, however, if the corporation received notice from the IRS regarding its S corporation status within six months of when it filed its first Form 1120S.

Corporations that are ineligible for relief under Rev. Proc. 97-48 can still ask for a letter ruling granting relief from the late S election.

This case study has been adapted from PPC’s Tax Planning Guide—S Corporations, 25th Edition, by Andrew R. Biebl, Gregory B. McKeen, George M. Carefoot, and James A. Keller, published by Practitioners Publishing Company, Ft. Worth, TX, 2011 ((800) 323-8724; ppc.thomson.com).