1. Electing S Corporation Status.
  1. In General.
  1. A small business corporation that wishes to avail itself of the benefits of the S corporation rules must file a timely election (§ 1362(b)). These rules are very inflexible, and failure to dot every "i" and cross every "t" can have disastrous tax consequences. Thus, to ensure an election is properly made, the utmost attention must be paid to every detail relating to the time and manner for making the S corporation election.
  1. Shareholders Consent.
  1. All persons who are shareholders on the day the election is made must file timely consents to the election (§ 1362(a)(1) and (2); Temp Reg. § 18.1362-2).
  1. Where a shareholder of a small business corporation dies before consenting to the corporation's § 1362 election to be an S corporation, an executor or administrator of the shareholder's estate may consent to the election on behalf of the decedent. Under § 6903, when a person acts for another person in a fiduciary capacity, the fiduciary assumes the powers, rights, and privileges of that person provided written notice has been made to the District Director. Consistent with this power, the executor, even though appointed after the date of the election, may consent to the election on behalf of the decedent and the decedent's estate (See Rev. Rul. 92-82, 1992-2 C.B. 238).
  1. If the election is filed after the first day of a corporation's taxable year, but on or before the 15th day of the third month of such taxable year, the consent of any person who held stock in the corporation during such taxable year and before the election is made is required to make the election effective for such year (§ 1362(b)(2)(B)(ii); Reg. § 1.1362-2(b)). If the election is to be made effective for the following taxable year, no consent need be filed by any shareholder who is not a shareholder on the date of the election (Reg. § 1.362-2(b)(1)).
  1. The election is made by the corporation filing Form 2553 (Reg. § 1.13621-1(b)). Form 2553 must be signed by any person who is authorized to sign Form 1120S and is to be filed with the Service Center designated in the instructions applicable to Form 2553.
  1. Note the revised Form 2553 reflects the new user fees imposed under Rev. Proc. 2002-1. Corporations filing Form 2553 and requesting a fiscal year under Rev. Proc. 87-32, 1987-2 C.B. 396, must pay a $600 user fee. However, the fee should not be paid with the election form; the IRS bills filers after it receives the form.
  1. The consent of each shareholder must be made on Form 2553 or on a separate statement attached to the Form 2553 (Reg. § 1.1362-2(a)). The consents of all shareholders may be incorporated in one statement (Reg. § 1.1372-3(a)). A shareholder's consent is binding and may not be withdrawn after a valid election is made by the corporation (but this does not preclude a decision to terminate the S corporation election) (Reg. § 1.1362-2(a)). The Service's acceptance of a filed Form 2553 does not prevent it from successfully arguing that an election was improper. Therefore, as long as the corporation continues to file as an S corporation, the validity of its election may be challenged. Even though the year of election has been closed by the statute of limitations (Reg. § 1.6037-1(c)), the election may be challenged in later open years and in years under an existing audit (T.H. Campbell and Brothers, 34 T.C.M. 694 (1975); Friends Winesellers, Inc., 31 T.C.M. 740 (1972); William James Hooper, 33 T.C.M. 759 (1974); Ray Mora, 31 T.C.M. 495 (1972)). Therefore, if the corporation believes that it has filed an invalid S corporation election in an earlier year, it should file a protective election to secure its status for the existing year and future years. Unless the substantive requirements of Form 2553 are met, the S corporation election is not effective (See also Smith v. Comm'r, 54 T.C.M. 1535 (1988); Smith S, Inc. v. Comm'r, 93-2 USTC ¶ 50,541 (E.D. NC, 1993); Barrett and Garrett, P.C. v. Comm'r, 66 T.C.M. 905 (1993); and Rockwell Inn, Ltd. v. Comm'r, 65 T.C.M. 2374 (1993) where the taxpayers' S election was denied because they did not comply with the filing requirements of the Form 2553 and, thus, were denied S corporation status).
  1. Recent Cases and Rulings Illustrating Filing Form 2553.
  1. The court held that a valid S election was not made where the taxpayer presented evidence of timely mailing of Form 2553. Because the taxpayer was not able to offer any evidence of the postmark, it was unable to avail itself of the timely-mailed, timely-filed rule contained in § 7502(a) (Carroll v. Comm'r, 67 T.C.M. 2995 (1994)). See also, Smith v. Comm'r, 67 T.C.M. 3086 (1994) where the court rejected the taxpayer's argument that the form must have been lost in the mail. The court admonished taxpayers to use certified mail.
  1. In Cabintaxi Corporation v. Comm'r, 68 T.C.M. 49 (1994), the court held that an election signed by the only shareholder was not valid because, at the time, the court had four other beneficial owners who had paid consideration for their stock but had not yet been issued stock.
  1. In Huff v. Comm'r, T.C. Memo 1994-477, a corporation's shareholders could not claim deductions for corporate losses where the corporation failed to properly elect S corporation status. The taxpayers failed to introduce sufficient evidence to create the presumption that Form 2553 had been properly addressed, mailed and received by the IRS. A copy of the form was introduced into evidence and was shown to be invalid on its face because it lacked the consent of all shareholders. The box titled "Shareholder's Consent Statement" was left blank next to the names of both shareholders, no Shareholder Consent Statement was attached to the form, and the signature of only one shareholder appeared on the form. The shareholders were liable for additions to tax for negligence in connection with the deductions they claimed on Form 2553 for the corporation's losses.
  1. In PLR 9424022 (March 15, 1994), the IRS ruled that a Form 2553 was valid even though incorrect dates were provided for its date of incorporation, the first day of its taxable year and the date on which its sole shareholder acquired his shares.
  1. Extensions of Time for Filing Consents - An election that is timely filed for any taxable year, and that would be valid except for the failure of any shareholder to file a timely consent, is not invalid for such reason, if:
  1. It is shown to the satisfaction of the District Director or Director of the Service Center with which the corporation files its income tax return that there was reasonable cause for the failure to file such consent and that the interests of the government will not be jeopardized by treating such election as valid.
  1. Such shareholder files a proper consent.
  1. New consents are filed within such extended period of time as may be granted by the Internal Revenue Service by each person who was required to consent to the corporation's S election (Reg. § 1.1362-6(b)(3)(iii).
  1. A valid election is effective for the taxable year of the corporation for which it is made and for all succeeding taxable years unless the election is terminated (§ 1362(c)).
  1. Making the Election.
  1. The election may be made at any time during the preceding taxable year (§ 1362(b)(1)(A)).
  1. The election may also be made at any time during the taxable year up to and including the 15th day of the third month of the taxable year (§ 1362(b)(1)(B)).
  1. If the election is made after the beginning of the taxable year, but on or before the 15th day of the third month of such taxable year, it is effective for such year only if the corporation qualified as a small business corporation on each day of this period (§ 1362(b)(2)(B)(i)).
  1. For newly-formed corporations, the election must be filed within the first 2½ months of the taxable year, which is deemed to begin upon the earlier of the date the corporation has assets, shareholders, or begins doing business (Reg. § 1.1362-6(a)(2)(ii)(C).
  1. Regulation § 1.1362-6(a)(2)(ii) provides that newly-formed corporations have a full 2½ months from the beginning of the taxable year to make the election. For example, a January 7 taxable year start would allow election through March 21. Furthermore, for taxable years of less than 2½ months, the election can still be made before the 15th day of the third month.
  1. The Service has held that the election is invalid if made before the corporation's formation. An election filed and approved before the state issues a certificate of incorporation is not valid because under state law there is no corporation until the certificate is issued (PLR 8530100 (May 1, 1985)).
  1. If a corporation makes an election for a taxable year after the 15th day of the third month of such taxable year, the election will be treated as made for the following taxable year (§ 1362(b)(3)).
  1. No provision for extension of time to file Form 2553 exists unless the taxpayer meets the requirements of Rev. Proc. 98-55.
  1. A missed election may be cured by merging a non-electing S corporation into an S corporation, the survivor being the S corporation. The C corporation would be required to file a short period return, and subsequent income would be included in the S corporation's return. This planning opportunity appears to be viable with respect to an existing S corporation and an existing C corporation. Forming an S corporation strictly to gain an election by merger of the C corporation may be viewed as a sham and should be carefully reviewed prior to suggesting this technique.
  1. If an election is made in the preceding year, only persons who are shareholders of the corporation on the day in which the election is made must consent to the election (§ 1362(a)(2); Reg. § 1.1362-6(a)(2)(ii). Persons acquiring stock between the date the election is made and the beginning of the year for which the election is effective need not consent to the election (Reg. § 1.1362-6(a)(2)(ii)(B)).
  1. Regulation § 1.1362-1(c) indicates that, for purposes of computing the 15th day of the third month, a month begins on the first day of the corporation's taxable year and runs to the day preceding the same numerical date in the succeeding month. For example, if a corporation begins its first taxable year on January 7, 1993, it must elect before March 22, 1993. The regulations count the first month as ending on February 7, and the second month on March 7, with the 15 days in the third month being March 7 through March 21. If the 15th day is a holiday, the next business day would presumably be acceptable (See § 7503).
  1. See also Reg. § 1.1362-6(a)(2)(ii)(C) which provides: "In the case of a new corporation, whose taxable year begins after the first day of a particular month, the term 'month' means the period commencing with the beginning of the first day of the taxable year and ending with the close of the date preceding the numerically corresponding day of the succeeding calendar month or, if there is no such corresponding day, with the close of the last day of such succeeding calendar month."
  1. But see Rev. Rul. 83-116, 1983-2 C.B. 264, which provides that § 7503 only applies to acts required to be performed in connection with determination, collection, or refund of taxes and does not apply to all time limits under the Code (for example, the 12 month period for complete liquidation under § 337 or the 10 year period for waiver of family attribution under § 302(c)(2)(A)(ii)) (Sander v. Comm'r, 41 T.C.M. 1416 (1981)).
  1. Who Must Consent - Generally, those counted as shareholders in determining eligibility for S corporation status must consent to the election (See Reg. § 1.1362-6(b)(1)).
  1. Both Spouses - Spouses who own stock as community or joint property are regarded as one shareholder for purposes of the maximum number of shareholder test. However, both must consent to the election. Id. For example, in Seely v. Comm'r, 51 T.C.M. 1087 (1986), the S corporation election was held invalid for failure to execute a valid election. In Seely, the taxpayers, husband and wife, purchased (with two other individuals) a restaurant and cocktail lounge which initially was operated as a partnership. The form of ownership was later changed to a corporation, and the shareholders attempted to elect S corporation status. Although the instructions on Form 2553 require both the husband and wife to sign if they have a community interest in the stock, only the husband signed the form. Although the Form 2553 listed the shares in the husband's name, they were, in fact, held as community property.
  1. Legal Guardian for Minor - The consent of a minor must be given either by the minor or by his legal representative (or by a natural or adoptive parent of the minor if no legal representative has been appointed) (Reg. § 1.1362-6(b)(2)). If stock is held for the minor by a custodian, the custodian has no power to consent on behalf of the minor unless the custodian is also the minor's legal or natural guardian (Rev. Rul. 66-116, 1966-1 C.B. 198).
  1. Executor for Estate - The consent of an estate is given by the executor or administrator (Reg. § 1.1362-6(b)(2)). The Service's position is that the executor or administrator of a deceased shareholder is to be regarded as the successor shareholder, provided the stock is properly subject to the administration and possession of the executor or administrator, notwithstanding that legal title passes directly to the devisees or heirs at law under state law (Rev. Rul. 62-116, 1962-2 C.B. 207).
  1. Grantor, Estate or Beneficiary - Under Reg. § 1.1362-2(b)(2), the following rules apply:
  1. In the case of a stock held by a grantor trust or by a QSST, the deemed owner must consent to the election (§ 1361(c)(2)(A)(i) and (B)(i); § 1361(d)(1)(A)).
  1. In the case of stock held by a testamentary trust, the estate of the testator must consent to the election (§ 1361(c)(2)(A)(iii) and (B)(iii)).
  1. In the case of stock held by a voting trust, each beneficiary must consent to the election (§ 1361(c)(2)(A)(iv) and (B)(iv)).
  1. Beneficial Owner - If stock is held by a nominee or agent, the beneficial owner must consent, not the nominee or agent (Rev. Rul. 70-615, 1970-2 C.B. 169; Wilson v. Comm'r, 560 F.2d 687 (5th Cir. 1977)).
  1. In determining beneficial ownership, the courts have looked to those shareholders who would be taxable on corporate distributions (Hoffman v. Comm'r, 391 F.2d 930 (5th Cir. 1968); Kean v. Comm'r, 469 F.2d 1183 (9th Cir. 1972); Wilson v. Comm'r, 560 F.2d 687 (5th Cir. 1977); see also Rev. Rul. 70-615, 1970-2 C.B. 169 and Rev. Rul. 75-261, 1975-2 C.B. 350).
  1. Buyer and Seller - If a sale of stock has not been completely consummated, both the buyer and seller should consent. The case law essentially concludes that the person (owner) who must consent to the election is determined by when the sale becomes effective for tax purposes (Alfred N. Hoffman, 47 T.C. 218 (1966); Pacific Coast Music Jobbers, Inc., 55 T.C. 866 (1971), aff'd, 457 F.2d 1165 (5th Cir. 1972)).
  1. Employees - In certain instances, a corporation may issue stock to an employee. However, if such stock is subject to a substantial risk of forfeiture and is not transferable, such individual is not deemed to be the owner of such stock under § 83. If the employee is not the owner of such stock under § 83, he should not be the owner under § 1361 for purposes of consenting to the S corporation election. The corporation should consider issuing options to acquire stock to its employees, provided certain conditions are met. Since an option is not equivalent to ownership of stock, employees' consent to an S corporation election is not required (Rev. Rul. 67-269, 1967-2 C.B. 298).
  1. Unlike the corporate election itself, the time for filing the shareholders' consents may be extended for reasonable cause provided the corporation's election has been timely filed (Reg. § 1.1362-2(c)).
  1. Effect of the Election on ITC.
  1. Formerly, if a corporation had claimed investment tax credit in taxable years preceding the year of an S corporation election (i.e., while it was a C corporation), an agreement providing that the shareholders and corporation would be jointly and severally liable for any subsequent recapture tax had to be filed (Reg. § 1.47-4(b)).
  1. Failure to file an agreement would result in full investment tax credit recapture at the time of election.
  1. Such an agreement is no longer required. Section 1371(d)(1) now specifically provides that an election will not trigger investment tax credit recapture. Therefore, the S corporation will remain liable for any recapture of investment tax credit taken during non-S corporation years (§ 1371(d)(2)).
  1. TRA 1986 eliminates investment tax credit for property placed in service after December 31, 1985, with an exception for certain transitional property.
  1. Proving that an S Election was Filed.
  1. Unfortunately, it is a familiar story. A newly electing S corporation files its first Form 1120S (U.S. Income Tax Return For An S Corporation). A few weeks later, it receives a notice from the IRS Service Center: "We have no record that you filed an S election. Please re-file your return on Form 1120."
  1. The fact pattern is frequently the same. The tax advisor prepared Form 2553 and sent it to the client with instructions to obtain the shareholders' signatures and to mail the form directly to the IRS Service Center. The client has no proof of mailing, but is adamant that the election statement was mailed on time.
  1. What's the likely outcome? Without proof of timely mailing, the corporation almost always loses. Listed below are some of the practical suggestions for minimizing "no record of S election" problems:
  1. Don't Wait Until the Last Minute to File an S Election - Most problem situations arise because the election is made so late that the client must file it directly with the IRS. Encourage the client to act early enough for the election form to be returned to you for filing.
  1. Never Rely on the Client to File an S Election - Failure to elect and late election problems are frequently attributable to relying on the client to mail the election to the IRS on a timely basis. Have the client return the form to you for filing. This, of course, requires following the preceding suggestion i.e., don't wait until the last minute to file an S election.
  1. Clarify Which Tax Advisor will be Responsible for Filing the S Election - Often, an electing corporation's accounting firm and law firm are both involved in the S election process. Sometimes, each assumes the other will handle preparation and submission of the S election form. Don't fall into this trap. Clarify filing responsibilities.
  1. Always Obtain Proof of Mailing and Delivery to the IRS - For hand deliveries, obtain a dated receipt stamp on a copy of the election form. Elections filed by mail should always be sent registered or certified mail with a return receipt requested. Identify the contents on the mailing receipt and on the green return receipt card - for example, X Co. Form 2553. In addition, enclose a copy of the election form with the request that it be date stamped and returned to you in an attached, pre-addressed, postage-paid envelope.
  1. Advise and Follow-up - If time constraints compel you to rely on the client to mail an S election form, advise the client of the importance of timely filing and of obtaining documentary proof of mailing. Follow-up with a phone call to confirm that it was sent on time.
  1. Verify IRS Receipt and Acceptance - Upon acceptance of an S election, the Service Center sends the corporation a confirmation letter. Generally, it should be received within 60 days after filing. If there has been no IRS response after three months, you should make an inquiry to the Service Center. Accordingly, after three months you should verify whether the corporation has received an acceptance letter. If so, a copy should be obtained for the permanent tax file.
  1. If you encounter a situation in which the IRS says it has no record that the client filed an S election, you might follow the following procedure:
  1. Have the client check its records to see if it has a letter from the IRS accepting the S election.
  1. Determine whether the client, its attorney, its accountants, or any other likely party has any proof of mailing documentation.
  1. Try to identify any facts that may provide circumstantial corroboration of mailing, for example, proof of filing a state election at the same time, or proof that the IRS received another document that was mailed in the same envelope.
  1. If your initial contacts with the Service Center personnel are not helpful, consider contacting the Problem Resolution Office at the Service Center. Failure to convince the Problem Resolution Officer that an S election was filed generally is fatal to the corporation's claim to S status.
  1. IRS May Waive Invalid S Elections.
  1. Under the rules in effect before the SBA, the IRS could waive an inadvertent termination of an S election, but not an invalid or late election. The SBA allows the IRS to treat a late subchapter S election as timely where the IRS determines that there was reasonable cause for the failure to make the election on a timely basis. The Blue Book indicates that it is intended that the IRS be reasonable in exercising this authority and apply standards that are similar to those applied under present law to inadvertent subchapter S terminations and other late or invalid elections.
  1. To validate a defective S election, a determination must be made by the Service that the termination of or ineffective S election was inadvertent, and that within a reasonable time after discovery, steps were taken to correct the problem (i.e., to qualify the corporation as a small business corporation or acquire the required shareholder consents) (§ 1362(f)(3)).
  1. In addition, the corporation and each shareholder must agree to make such adjustments to their income (consistent with the corporation's status as an S corporation) as required by the Service (§ 1362(f)(4)).
  2. It is most likely that the only way that the Service can validate a late S election is for the taxpayer to submit a private letter ruling request making the determination that the late S election was inadvertent.
  1. This provision is retroactively effective for elections made in taxable years beginning after December 31, 1982.
  1. Inadvertent Invalid S Corporation Elections and Late S Corporation Elections.
  1. Ann. 97-4 (January 3, 1997) informs taxpayers of § 1362(b)(5) that allows the IRS to treat a late subchapter S election as timely made and to waive the defects in an inadvertent invalid S election.
  1. Late Subchapter S Election.
  1. A small business corporation must elect to be an S corporation no later than the 15th day of the third month of the taxable year for which the election is effective. Under prior law, the IRS did not have the authority to validate a late election.
  1. New § 1362(b)(5) allows the Secretary to treat an election to be an S corporation as timely filed if either the election is made after the date prescribed or no such election was made, provided the Secretary determines there was reasonable cause for the failure to timely file the S election.
  1. Generally, in order to obtain relief under § 1362(b)(5), a taxpayer must receive a private letter ruling from the IRS. The procedural requirements for requesting a ruling are described in Rev. Proc. 97-1.
  1. However, a special transition rule for seeking relief under § 1362(b)(5) is provided for untimely S corporation elections made for a taxable year beginning in 1996. Under this rule, taxpayers who did not file an S corporation election in a timely fashion for the 1996 taxable year may re-seek relief under § 1362(b)(5) by submitting on or before February 15, 1997, an S corporation election to the applicable Service Center as well as a letter explaining the reasonable cause for the untimely S corporation election.
  1. Any taxpayer who is not eligible for the relief under the special transition rule described above may request relief by applying for a private letter ruling.
  1. Invalid S Corporation Elections.
  1. Under prior law, if the IRS determined that a corporation's subchapter S election was inadvertently terminated, the IRS could waive the effect of the terminating event for any period if the corporation timely corrected the event and if the shareholders agree to be treated as if the election had been in effect for that period. Such waivers generally are obtained through the issuance of a private letter ruling. Prior law did not grant the IRS the ability to waive the effect of an inadvertent invalid subchapter S election.
  1. New § 1362(f) applies the inadvertent termination relief rules in situations where an election by a corporation to be treated as a small business corporation was invalid due to a failure to meet the requirements of an S corporation found in § 1361(b) or to obtain all of the shareholder consents.
  1. Generally, in order to obtain relief for inadvertent invalid elections, the corporation must request a private letter ruling from the IRS. Reg. § 1.1362-4(c) thru (f) provide rules for corporations requesting inadvertent termination relief under § 1362(f). These rules will also apply to corporations requesting inadvertent invalid election relief.
  2. In situations where taxpayers failed to obtain all of the necessary shareholder consents on Form 2553, Reg. § 1.1362-6(b)(3)(iii) provides rules for obtaining § 1362 relief from the District Director or Director of the Service Center for which the corporation files its income tax return.
  1. IRS Exercises New Power to Waive Faulty S Elections.
  1. In PLR 9716024, two individuals incorporated the corporation intending it to be an S corporation. The two individuals relied on the corporation's attorney to file the appropriate documents but no election was prepared or filed. The corporation filed a Form 1120S for its first taxable year. IRS notified the corporation that no S election had been filed. Subsequently, the owners contacted the corporation's attorney and discovered that no S election had been submitted. When the corporation was informed that it was not an S corporation, it filed an S election.
  1. IRS ruled that the corporation established reasonable cause for not making its S election and was entitled to relief under § 1362(b)(5).
  1. IRS ruled that the corporation will be treated as a subchapter S corporation from the date it intended to file for the S election.
  1. In PLR 9719009, the owner of a corporation decided to elect S in year two of the corporation's existence. The owner represented that she delivered the S corporation election to an employee of the corporation who was supposed to mail it. "However, the employee [represented] that the employee did not mail in the S corporation election." The corporation filed an 1120S for year two, and was notified by the IRS that no S election had been filed. The corporation immediately mailed an S corporation election to the IRS, and requested a private letter ruling.
  1. IRS ruled that the corporation established reasonable cause for not making its S election and was entitled to relief under § 1362(b)(5).
  1. IRS ruled that the corporation will be treated as a subchapter S corporation from the date it intended to file for the S election - the beginning of year two.
  1. No-Fee Procedure For Requesting Relief For Late S Elections.
  1. The SBA gave IRS authority to treat late S corporation elections as timely filed. Until recently, S corporations had a request a private letter ruling to obtain relief. In Rev. Proc. 98-55, 1998-46 I.R.B. 24, the IRS establishes a new procedure allowing corporations to seek relief without incurring a user fee for requesting a private letter ruling. (See Appendix A.)
  1. To obtain relief under the new procedure, eligible corporations must, within t12 months of the original election due date, file a competed Form 2553, "Election by Small Business Corporation," with the applicable service center.
  1. The form must be signed by a corporate officer and all persons who were shareholders during the period that began on the first day of the tax year for which the election takes effect; and ends on the day the election was made.
  1. The top of the form must state "FILED PURSUANT TO REV. PROC. 98-55."
  1. A statement explaining the reason for the failure to file the S corporation election must also be attached.
  1. If, after reviewing the completed application, the Service decides there was reasonable cause for the failure to file a timely election, it will notify the corporation of that fact.
  1. To be eligible for relief under the procedure:
  1. A corporation must fail to qualify as an S corporation solely because the Form 2553 was not filed timely under § 1362(b)(1); and
  1. The due date for the tax return (excluding extensions) for the first year the corporation intended to be an S corporation has not passed.
  1. Ineligible corporations, or corporations denied relief under the procedure, however, must still apply for a private letter ruling under Rev. Proc. 2002-1, if they desire relief.
  1. Rev. Proc. 98-55 also allows a corporation with a valid S election relief for failing to file a timely Q-Sub election if specific requirements (including a reasonable clause requirement) are met. As with the above relief, the Q-Sub election must be filed within a year of its due date to be effective on the desired effective date, but not later than the due date for the S corporation's tax return (excluding extensions) for the first year of the S corporation for which it intended to treat the subsidiary as a Q-Sub.
  1. In addition, Rev. Proc. 98-55 provides guidance for corporations seeking automatic inadvertent invalid election relief or inadvertent termination relief because the beneficiary of a QSST failed to file a timely QSST election or the trustee of the trust that would otherwise qualify as an ESBT, failed to file a timely ESBT election. To qualify, all taxpayers whose tax liability and tax returns would be affected by the QSST or ESBT election must have reported their income consistent with the corporation's S election for the year the QSST or ESBT election should have been made, as well as for any subsequent year. Corporations satisfying this and other requirements are automatically granted the relief and will be treated as S corporations on the date of termination or the date on which the election was to become effective.
  1. IRS Rev. Proc. 97-48 Granting Automatic Relief for Late S Corporation Elections in Two Situations. Situation 1: Automatic Relief Where Return Filed as an S Corporation: The corporation failed to qualify as an S corporation solely because the Form 2553 (Election by a Small Business Corporation) was not filed timely;
  1. 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 taxable year (if any);
  1. At least six months have elapsed since the date on which the corporation filed it tax return for the first year and the corporation intended to be an S corporation; and
  1. Neither the corporation nor any of its shareholders was notified by the IRS of any problem regarding the S corporation status within six months of the date on which the Form 1120S for the first year was timely filed.
  1. Procedural Requirements for Automatic Relief. The corporation must file with the applicable service center ( or district director if under examination) a completed Form 2553, signed by an officer of the corporation authorized to sign and all persons who were shareholders at any time during the period that the corporation intended to be an S corporation. The Form 2553 must state at the top of the document "FILED PURSUANT TO REV. PROC. 97-48." Attached to the Form 2553 must be a dated declaration signed by an officer of the corporation authorized to sign and all persons who were shareholders at any time during the period that the corporation intended to be an S corporation, attesting (but, in the case of a shareholder, only with respect to that shareholder) that:
  1. The corporation and the shareholder reported their income (on all affected returns) consistent with S corporation status for the year the S corporation election should have been made, and for every subsequent taxable year; and
  1. "Under penalties of perjury, to the best of my knowledge and belief, the facts presented in support of this election are true, correct, and complete."
  1. Situation 2: Automatic Relief Where First Intended S Corporation Year Filed as A C Corporation. Eligibility for Automatic Relief. Automatic relief is available in Situation 2 if all the following conditions are met:
  1. The corporation fails to qualify as an S corporation solely because the Form 2553 (Election by a Small Business Corporation) was not filed timely for a taxable year that began prior to January 1, 1997;
  1. The corporation received notification from the IRS that the Form 2553 was not filed timely, that the corporation must file as a C corporation for the first taxable year the corporation intended to be an S corporation, and that the election would be treated as an S corporation election for the following taxable year;
  1. The corporation and all of its shareholders reported their income (if any) properly treating the corporation as a C corporation for the first taxable year the corporation intended to be an S corporation;
  1. The corporation and all of its shareholders reported their income consistent with S corporation status for all subsequent years;
  1. The period of limitations on assessment under § 6501(a) has not lapsed for any of the taxable years of the corporation intended to be taxable as an S corporation; and
  1. The period of limitations on assessment under § 6501(a) has not lapsed for any taxable year of any of the corporation's shareholders in which any taxable year ends.
  1. Procedural Requirements for Automatic Relief. The corporation must file with the applicable service center (or district director if under examination) a completed Form 2553, signed by an officer of the corporation authorized to sign and all persons who were shareholders at any time during the period that the corporation intended to be an S corporation. The Form 2553 must state at the top of the document "FILED PURSUANT TO REV. PROC. 97-48." Attached to the Form 2553 must be a dated declaration signed by an officer of the corporation authorized to sign and all persons who were shareholders at any time during the period that the corporation intended to be an S corporation, attesting (but, in the case of a shareholder, only with respect to that shareholder) that:
  1. The corporation and the shareholder reported (on all affected returns) consistent with the requirements for automatic relief under section 4.02 of Rev. Proc. 97-48;
  1. The corporation and the shareholder agree to amend their tax returns for the first year and any other affected returns to reflect S corporation status; and
  1. "Under penalties of perjury, to the best of my knowledge and belief, the facts presented in support of this election are true, correct, and complete."
  1. Relief for Late S Corporation Election. A corporation that satisfies the requirements of either section 4.01 or 4.02 of Rev. Proc. 97-48 will be deemed to have reasonable cause for the failure to file a timely S corporation election and will automatically be granted relief to file the election for S corporation status to commence on the date that it intended to have the S corporation election become effective. The IRS will notify the corporation of the acceptance of its untimely filed S corporation election under the Revenue Procedure, or the denial of a request that fails to satisfy the requirements of Rev. Proc. 97-48.
  1. Section 5: Examples: S Corporation Return Filed and No Notification From the Service. A, B, and C formed X Corporation on January 1, 2002. X intended to file an S corporation election; however, X did not file a timely Form 2553 (Election By A Small Business Corporation). On March 13, 2003, X files a Form 1120S (S corporation income tax return) for the 2002 taxable year, and A, B, and C file their individual tax returns as if X were an S corporation. In November 2003, X realizes that an S corporation election was not timely filed. Neither X, nor its shareholder, received any notification from the IRS of any problem regarding the S corporation status of X. In this case, the shareholders and X meet the requirements of section 4.01 of Rev. Proc. 97-48. Consequently, X will be granted automatic late S corporation election relief if A, B, C, and X file a request for relief in accordance with the procedures described in this revenue procedure.
  1. C Corporation Return for First Year. A formed X corporation on January 1, 1995. X intended to file an X corporation election effective as of January 1, 2001; however, X did not file a Form 2553 (Election by a Small Business Corporation) until May 5, 2001. On June 15, 2001, X received a letter from the Service notifying X that its S corporation election was denied for the 2001 taxable year because the S corporation election was not timely filed, and that the election would be treated as effective for the 2002 taxable year. X filed a Form 1120 (C corporation income tax return) for the 2001 taxable year and A filed the individual tax return for 2001 as if X were a C corporation. For the 2002 taxable year, X filed a Form 1120S (S corporation income tax return), A filed the individual tax return as if X were an S corporation. The period of limitations on assessment under § 6501(a) has not lapsed for either the 2001 or the 2002 taxable years for either X or for A. In this case, A and X meet the requirements of section 4.02 of Rev. Proc. 97-48. Consequently, X will be granted automatic late S corporation election relief if X and A file a request for relief in accordance with the procedures described in the Revenue Procedure.
  1. Incorporating a Partnership and Filing Form 8832.
  1. Incorporating a Partnership.
  1. Partners who decide to incorporate a partnership may do so in one of three ways:
  1. Under alternative one, the partnership transfers its assets to a newly formed corporation (New Co.) in exchange for New Co.'s stock and New Co.'s assumption of the partnership liabilities. The partnership then makes a terminating distribution of the New Co. stock to the partners.
  1. Under alternative two, the partnership makes a terminating distribution of its assets and liabilities to the partners. They, in turn, transfer the assets to New Co. in exchange for New Co.'s stock and New Co.'s assumption of the liabilities.
  1. Under alternative three, the partners transfer their partnership interests to New Co. in exchange for its stock. The exchange terminates the partnership and all of its assets and liabilities become assets and liabilities of New Co.
  1. According to Rev. Rul. 84-111, 1984-2 C.B. 88, each alternative has different tax consequences. Accordingly, the most advantageous way to incorporate a particular partnership depends on the particular facts and circumstances. However, it had previously been unclear whether alternative one would be available when the parties intend that New Co. will make an S election effective as of the first day of its existence.
  1. Since a partnership cannot be an S corporation shareholder, it had been unclear whether a partnership's momentary ownership of New Co.'s stock in alternative one would preclude New Co. from making an S election for its initial taxable year (and possibly being subject to the built-in gains tax under § 1374 for succeeding years). The IRS had ruled that momentary ownership of the stock of a corporation by another corporation pursuant to a plan or acquisition or reorganization would be disregarded for purposes of the S corporation shareholder eligibility requirements. (See Rev. Rul. 72-320, 1972-1 C.B. 270, and Rev. Rul. 73-496, 1973-2 C.B. 312.) The IRS, however, had never ruled on the issue of momentary ownership by a partnership.
  1. In PLR 8926016 (March 29, 1989) and PLR 9421022 (February 24, 1994), the IRS extended the momentary ownership analysis of Rev. Rul. 72-320 to ownership by a partnership. In the rulings, two partnerships transferred all their respective assets to New Co. in exchange for New Co.'s stock and New Co.'s assumption of the partnership liabilities. The partnerships then immediately distributed the New Co. stock to their respective partners in proportion to their partnership interest. Citing Rev. Rul. 72-320, the IRS ruled that the partnership's momentary ownership of New Co. stock would be disregarded. The partners would be treated as New Co.'s only shareholders. New Co. would therefore by eligible to make an S election, effective as of its first day of existence (all the partners in both partnerships were individuals who qualified as S corporation shareholders).
  1. Filing Form 8832.
  1. Under Reg. § 301.7701-3(g), if an eligible entity classified as a partnership elects to be classified as association, the following is deemed to occur:
  1. The partnership contributes all of its assets and liabilities to the association in exchange for stock in the association, and immediately thereafter, the partnership liquidates by distributing the stock of the association to its partners. Reg. § 301.7701-3(g) does not affect the holdings in Rev. Rul. 84-111, 1984-2 C.B. 88, in which the IRS ruled that it would respect the particular form undertaken by the taxpayers when a partnership converts to a corporation.
  1. Section 743 provides that the basis of partnership property is not adjusted as the result of a transfer of an interest in the partnership by sale or exchange unless the partnership has made an election under § 754. If a § 754 election is made, the transferee partner is treated as having a special basis adjustment with respect to partnership property. This adjustment constitutes an adjustment to the basis of partnership property with respect to the transferee partner only. The regulations provide that a corporate transferee's basis in property transferred by a partnership in a transfer described in § 351 includes any special basis adjustment under § 743. The special basis adjustment is also taken into account in determining the partner's basis in the stock received in the exchange.
  1. For example, assume a partnership owns property X, which has common basis of $100 for the partnership and in which partner A has a $5 special basis adjustment under § 743(b). Subsequently, the partnership validly elects to be classified as an association by filing Form 8832. The partnership is deemed to contribute all of its assets and immediately thereafter, the partnership liquidates by distributing the stock of the association to its partners. If the transfer of the assets to the association would be a transfer described in § 351, then under the regulations, the association's basis in property X includes partner A's $5 special basis adjustment. Thus, the association has a $105 basis in property X (partner A's $5 special basis adjustment plus the partnership's $100 common basis). Partner A's basis in the association's stock will reflect the $5 special basis adjustment previously on property X.
  1. Reg. § 301.7701-3(g) also provides that the amount of gain, if any, recognized by the partnership on the transfer is determined without reference to any special basis adjustment. The partner with the special basis adjustment can then use the special basis adjustment to reduce its share of any gain recognized by the partnership. This approach of determining gain at the partnership level and allowing the partner to use the special basis adjustment as an offset is similar to the treatment of the sale of property with a special basis adjustment.