Fixing a Terminated S Corp. Election
Many small and mid-size companies elect to do business as an S corporation. If the election is made correctly and the qualification rules are followed, the corporation will pay no income taxes. Income and gain are calculated by the corporation; but that income and gain pass through to the shareholders who pay the tax. Should, however, the Small Business Corporation qualification rules be violated, the S corporation election terminates, and the corporation pays tax. The shareholders also may be subject to tax on previously taxed corporate profits distributed as dividends.
Failure to adhere to the following qualification rules can cause an S Corp. election to be violated from the outset or cause the termination of an S Corp. election at a later date:
- Excess Shareholders (e., more than 100 for taxable years after 2004);
- Ineligible shareholder (g., nonresident aliens, C Corporations, partnerships (including multi-member LLCs));
- More than one class of stock (other than voting and non-voting common stock);
- Business Operations make the corporation ineligible to elect S Corp. status (g., insurance company);
- S Corp. with passive income in excess of 25% of gross receipts for 3 consecutive years with prior C Corp. earnings and profits; and
- Failure to use a permissible taxable year.
Ineligible shareholder rule is commonly violated.
Two persons start a new business and elect to be an S Corp. A is a Texas native. B is from Texas but has moved to the United Kingdom and relinquished his U.S. citizenship. Because B is no longer a U.S. person, he is a nonresident alien who is not an eligible shareholder. The ineligible shareholder rule is violated, and the S Corp. election is ineffective. I.R.C. §1361(b)(1)(B).
One class of stock rule also is commonly violated.
S Corp. has two shareholders, A and B. Each owns 500 shares of stock in the corporation. The corporation’s shareholder agreement provides that A will be in charge of the day-to-day operation of the business and, in lieu of a salary, A will receive 70% of the cash distributed by the corporation. B will receive 30% of the cash distributed. Because the corporate shareholder agreement does not confer identical distribution and liquidation rights for the outstanding shares of stock in the corporation, the corporation has a second class of stock, which violates the one class of stock rule. I.R.C. §1361(b)(1)(D); Treas. Reg. §1361(l)(2).
Automatic Consent to Re-Elect S Corp Status After Ineffective Election.
Care must be taken before filing the S Corp. election to avoid violating the ineligible shareholder rule and the one class of stock rule. If these eligibility rules are violated, the election is defective from the outset. Should, however, the election be discovered and remedied the taxpayer can make a new automatic election immediately. However, the new election does not relate back to the filing or effective date of the original defective election. The new election will be effective at the beginning of the corporation’s next tax year, which is typically January 1st. See Treas. Reg. § 1.1362-5(c)(2). Until then the corporation is taxed as a C corporation for federal income tax purposes.
In both of the examples above the S Corp. election never took effect.
What happens if a termination occurs after the S Corp. election is effective?
A owns all of the membership interests in a single-member LLC that is a disregarded entity for federal tax purposes. Through her LLC A invests in an S Corp. owned by B. Both A and B are U.S. citizens. The S Corp. election is not terminated because of A’s investment through her LLC because it is a disregarded entity so that A is treated as if she owns her stock in the S Corp. directly.
At a later date, A transfers a 10% membership interest in her LLC to X, a key employee in her business. On the day that A transfers her membership interest to X the LLC is reclassified from a disregarded entity to a partnership for federal tax purposes. See Treas. Reg. 301.7701-3(f)(2) & (f)(4), Example (1). Because partnerships are ineligible owners of S Corp. stock the S Corp. election terminates effective on the day the termination event occurs and the corporation becomes a C Corp. on that date. See Treas. Reg. § 1.1362-3(a).
Inadvertent Terminations Can Be Fixed—With Time
Retroactive reinstatement of a terminated S Corp. election is possible if certain conditions are met and a ruling is obtained from the IRS Chief Counsel’s Office in Washington, D.C. allowing the reinstatement.
If the corporation made a valid S Corp. election and the IRS determines that the termination was inadvertent a ruling may be forthcoming if within a reasonable period of time after discovery of the terminating event steps were taken to correct the problem. Another condition to the ruling is that the corporation and shareholders agree to make any adjustments required by the IRS for the period after which the termination occurred. Because the corporation has the burden of establishing that the termination was inadvertent, it is important to marshal the facts and present a detailed explanation of the event or circumstances that led to the inadvertent termination. Treas. Reg. § 1362-4.
A review of the public rulings in this area show that the IRS can be reasonable in their grant of relief if circumstances warrant. Although reinstatement is not always granted retroactively back to the termination date, retroactive reinstatement is not uncommon.
What if an S Corp Election previously filed with the IRS is missing?
Although rare the IRS may not have any record of the taxpayer’s S Corp. election on file (IRS Form 2553). If the taxpayer does not have a signed copy of the IRS Form along with proof of filing but the corporation has been filing as an S Corp. and the shareholders have been filing as shareholders of an S Corp., a re-filed late election may be accepted if made within 3 years and 75 days of the proposed effective date of the election. Rev. Proc. 2013-30. If outside this deadline, a ruling as described above may be available.