In my practice, I have seen various issues related to a taxpayer’s S election. Corporations potentially jeopardize their S election by unknowingly creating a second class of stock through convertible debt. Corporations, particularly in community property states, may jeopardize their S election for failing to obtain the consent of the shareholders’ spouses. Or, corporations may simply fail to make a timely S election by submitting Form 2553 to the Service. In a recent Private Letter Ruling, the Internal Revenue Service determined that the taxpayer established reasonable cause for failing to timely file its S election.
S Elections & Timing, Generally
Generally, a small business corporation may elect to be treated as an S corporation.[1] For purposes of the U.S. Tax Code, a small business corporation is eligible if it is a domestic corporation that does not have more than 100 shareholders, does not have a shareholder that is not an individual, does not have a nonresident alien as a shareholder, and does not have more than one class of stock.[2]
Section 1362(b) describes when an S election is effective:
(1) In General
An election under subsection (a) may be made by a small business corporation for any taxable year—
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- (A) at any time during the preceding taxable year, or
- (B) at any time during the taxable year and on or before the 15th day of the 3d month of the taxable year.
(2) Certain elections made during 1st 2½ months treated as made for next taxable year
If—
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- (A) an election under subsection (a) is made for any taxable year during such year and on or before the 15th day of the 3d month of such year, but
- (B) either—
- (i) on 1 or more days in such taxable year before the day on which the election was made the corporation did not meet the requirements of subsection (b) of section 1361, or
- (ii) 1 or more of the persons who held stock in the corporation during such taxable year and before the election was made did not consent to the election, then such election shall be treated as made for the following taxable year.
(3) Election made after 1st 2½ months treated as made for following taxable year
If—
-
- (A) a small business corporation makes an election under subsection (a) for any taxable year, and
- (B) such election is made after the 15th day of the 3d month of the taxable year and on or before the 15th day of the 3rd month of the following taxable year, then such election shall be treated as made for the following taxable year.
(4) Taxable years of 2½ months or less
For purposes of this subsection, an election for a taxable year made not later than 2 months and 15 days after the first day of the taxable year shall be treated as timely made during such year.
(5) Authority to treat late elections, etc., as timely
If—
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- (A) an election under subsection (a) is made for any taxable year (determined without regard to paragraph (3)) after the date prescribed by this subsection for making such election for such taxable year or no such election is made for any taxable year, and
- (B) the Secretary determines that there was reasonable cause for the failure to timely make such election, the Secretary may treat such an election as timely made for such taxable year (and paragraph (3) shall not apply).[3]
The Internal Revenue Service provides taxpayers the opportunity to cure an untimely S election given the proper circumstances. Much like other areas where a taxpayer may invoke reasonable cause (e.g., penalty abatement, trust fund recovery penalties, etc.), a taxpayer may use reasonable cause as a defense to failing to make a timely S election.
Private Letter Ruling 202045006
Earlier this month, the Internal Revenue Service issued a Private Letter Ruling (“PLR”) related to a taxpayer’s request for relief under Section 1362(b)(5) to file a late S election.[4] The PLR states in part:
The information submitted states that X was formed as a limited liability company on Date under the laws of State and timely filed an entity classification election to be classified as an association taxable as a corporation for federal tax purposes. X represents that it always intended to be treated as an S corporation for federal tax purposes beginning on Date. However, X represents that it failed to properly and timely file Form 2553, Election by a Small Business Corporation, effective for Date. X further represents that it and its sole shareholder have always filed their federal tax returns consistent with X‘s treatment as an S corporation.
. . .
Based solely on the facts submitted and the representations made, we conclude that X has established reasonable cause for failing to make a timely election to be an S corporation effective Date. Accordingly, provided that X makes an election to be an S corporation by filing a completed Form 2553 effective Date, along with a copy of this letter, with the appropriate service center within 120 days from the date of this letter, then such election will be treated as timely made for Date.[5]
Conclusion
Interestingly, the Internal Revenue Service concluded that the taxpayer established reasonable cause solely based on its intent and the fact that the taxpayer and its sole shareholder filed tax returns consistent with treating the taxpayer as an S corporation. The IRS came to this conclusion despite the fact that the taxpayer timely filed a federal entity classification election, and the taxpayer did not apparently make a representation as to why its S election was not timely.
While the taxpayer received a favorable determination from the IRS in this case, taxpayers should make every effort to make a timely S election. Moreover, taxpayers should be sure to shore up their arguments in the event their S elections are untimely—even though the IRS set a relatively low bar in this case. Ultimately, however, taxpayers should be mindful of various considerations relative to their treatment as S corporations. Filing Form 2553 is just the tip of the iceberg.
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[1] See I.R.C. § 1362(a)(1); see also I.R.C. § 1362(g) (limiting elections after an election has terminated).
[2] See I.R.C. § 1361(b)(1). Notably, certain estates, trusts, or other organizations may serve as shareholders, while certain types of corporations, such as DISCs, are ineligible.
[3] I.R.C. § 1362(b) (emphasis added).
[4] I.R.S. Priv. Ltr. Rul. 202045006 (Nov. 6, 2020).
[5] Id.
