Avoiding inadvertent termination of an S election

If an S corporation fails to maintain its status as a "small business corporation" under Sec. 1361(b), its S election automatically terminates on the date the disqualifying event occurs. The disqualifying events that can terminate S status include the following (Secs. 1362(d)(2) and 1361(b)(1); Regs. Sec. 1.1362-2(b)(1)):

• Having more than 100 shareholders. The S corporation can have more than 100 shareholders in total during the year as long as there are no more than 100 shareholders at any given time.
• Having an ineligible shareholder (e.g., a corporation, partnership, ineligible trust, or nonresident alien). Partnership and corporate shareholders generally are not permitted, other than so-called transitory ownership as part of a corporate reorganization.
• Having more than one class of stock. Differences in voting rights are allowed, which can be useful, for example, when transferring nonvoting common stock to younger family members or trusted employees.
• Becoming an ineligible corporation such as an insurance company or a domestic international sales corporation.
• Transferring place of incorporation to a foreign country (thus no longer qualifying as a domestic corporation).

The IRS issued technical advice stating that a corporation's S election was not terminated by using an impermissible tax year (Technical Advice Memorandum 9505003). Sec. 1362 provides the specific events that can cause a corporation to fail to meet the definition of a small business corporation. Filing income tax returns based on an improper year end is not an event under Sec. 1362 that causes disqualification.

The IRS privately ruled that a corporation that qualified as an S corporation under Sec. 1361(b) prior to a state's administrative dissolution (when the corporation failed to timely file its annual report and pay its annual license fee) was not required to file a new S election under Sec. 1362(a) (IRS Letter Rulings 9411040 and 200835002). Similarly, an S corporation that did not know it had been administratively dissolved for the nonpayment of fees was not required to file a new election. The corporation had continued to file Form 1120-S, U.S. Income Tax Return for an S Corporation, and later reincorporated (IRS Letter Ruling 201237001).

In another letter ruling, the corporation filed a final tax return but took no action to dissolve itself. Later, the state administratively dissolved but retroactively reinstated the corporation. Based on conflicting advice, the corporation obtained a new employer identification number (EIN). Since the corporation qualified as an S corporation under Sec. 1361(b) before it was administratively dissolved, its status did not terminate upon its dissolution. However, a corporation ordinarily would not apply for a new EIN upon its retroactive reinstatement under state law. Since the corporation had applied for and received a new EIN, it had to file a new Form 2553, Election by a Small Business Corporation, with the appropriate Service Center (IRS Letter Ruling 200535017).

Unintended termination of the S election can occur because of circumstances that are more obscure than a shareholder selling stock to a corporation, nonresident alien, or other ineligible shareholder. For example, termination can occur if:

• The successor beneficiary of a qualified Subchapter S trust (QSST) affirmatively refuses to consent to the original QSST election, which means the QSST is no longer an eligible S corporation shareholder;
• S corporation stock is pledged as collateral for a personal loan and, upon default, is acquired by an ineligible shareholder pursuant to a foreclosure sale (IRS Letter Ruling 9138025);
• An S corporation that has accumulated earnings and profits (AE&P) receives more than 25% of its gross receipts from passive investment income in three consecutive years; or
• A shareholder dies, and the estate holds the S corporation stock for more than two years (Regs. Sec. 1.1361-1(h)(3)(i)(B)).

Note: A bankruptcy estate is an eligible S corporation shareholder. Thus, a Chapter 7 or Chapter 11 bankruptcy petition filed by an S corporation does not cause the S election to terminate. The Ninth Circuit has held that a corporation's prebankruptcy revocation of its S election was a "transfer" that was avoidable by the bankruptcy trustee (In re Bakersfield Westar, 226 B.R. 227 (Bankr. 9th Cir. 1998)). The corporation's prebankruptcy "right" to make or revoke an S election was "property" or "an interest of the debtor in property" under the Bankruptcy Code. Furthermore, a prepetition revocation of S status was a "transfer" that could be avoided by the trustee under Bankruptcy Code Section 548(a). Once a revocation is avoided, it is treated as if it had never been made, and the trustee is free to act as he or she sees fit. In another case, the Third Circuit found that S corporation and qualified Subchapter S subsidiary status are not property and remanded the case to the bankruptcy court with orders to dismiss the complaint for lack of jurisdiction (Majestic Star Casino v. Barden Dev., 716 F.3d 736 (3d Cir. 2013)).

The Tax Court has ruled that Sec. 1362(d) does not provide an exclusive list of factors that can cause the S election to terminate. For example, in one case, the S election terminated because the S corporation did not adopt a permitted year after conditions changed in such a way that the year it was using no longer constituted an allowable fiscal year. (See Farmers Gin, T.C. Memo. 1995-25.)

QSSTs under Sec. 1361(d) and electing small business trusts (ESBTs) under Sec. 1361(e) are entities that can qualify to be Subchapter S shareholders. In order for a QSST to be qualified, a beneficiary of the trust must make the election to be treated as an eligible S shareholder. A trustee of an ESBT must file the election for such a trust to be treated as an eligible S shareholder. If either election is not made on a timely basis within two months and 16 days of the trust's receipt of the stock, the S election for the corporation is inadvertently terminated.

Relief can be obtained from a missed QSST or ESBT election by following the procedures found in Rev. Proc. 2013-30.

This case study has been adapted from Checkpoint Tax Planning and Advisory Guide's S Corporations topic. Published by Thomson Reuters, Carrollton, Texas, 2022 (800-431-9025; tax.thomsonreuters.com).