S Corp Election

1. S Corp Election

2. S Corp Election • An eligible corporation may elect S status. • All shareholders must consent to the election. • The election (and shareholder consent) is made on IRS form 2553. • No need to file Form 8332 if an LLC files form 2553 and opts to be taxed as an S corporation.

3. S Corp Election • To be effective as of the beginng of the taxable year, and IRS form 2553 must be filed (i.e., the election must be made): • during the prior year, or • on or before the fifteenth day of the third month of the current taxable year. • See Reg. 1.1362-6 for details.

4. S Corp Election • With late S elections caused by inadvertence, IRS may waive the defect. Code Sec. 1362(f).

5. S Corp Election Revocation

6. S Corp Election Revocation • An S election may be revoked if shareholders holding more than 50% of the corporation’s shares consent to the revocation. • Note that a shareholder owning 1 share of stock may, in effect, revoke the S election by transfering that 1 share of stock to an ineligible shareholder (such as an IRA or a nonresident alien).

7. Termination of S Corp Election

8. Failure To Be a Small Business Corporation • An S corporation terminates if it fails to satisfy the definition of a Sec. 1361(b) “small business corporation”. For example: • Over 100 shareholders • Issuance of a second class of stock. • Ineligible shareholders such as an IRA or nonresident alien.

9. Excess Passive Investment Income • Under Section 1362(d)(3), an S corporation election terminates if, for three consecutive years: • the corporation’s “passive investment income” exceeds 25% of its gross receipts, and • the corporation has Subchapter C earnings and profits.

10. Inadvertent Terminations

11. Inadvertent Terminations • Following a termination of an S election, a corporation generally is not eligible to make another election for five taxable years unless the IRS consents to an earlier election. Sec. 1362(g). • Section 1362(f) authorizes the IRS to grant relief from an inadvertent termination.

12. Tax Year of S Corporation

13. Section 1378 Permitted Year • Calendar year, or • A year for which the taxpayer establishes a business purpose • A natural business year (deemed business purpose) exists if 25% or more of the S Corporation’s gross receipts for the selected 12-month period are earned in the last two months (for the prior three years). See Rev Proc 2002-38.

14. 444 Election • An S corporation can use a tax year other than the permitted year with a Section 444 election. • Sec 444 permits a newly formed S corporation to elect to use a taxable year that results in no more than a three-month deferral of income to the shareholders (Sec 7519 payment is required).

15. Change in Year Under Sec 444 • With an existing S corporation, a change in the tax year can be made with a Section 444 election provided the deferral period is no longer than the shorter of: • 3 months, or • the deferral period of the tax year which is being changed. Sec. 444(b)(2)

16. Change in Year Under Sec 444 • Assuming the permitted year is a calendar year, an S corp can change from a Sept. fiscal year end (3 mo. deferral) to an Oct. fiscal year end (2 mo. deferral). If you already have been using a calendar year (zero deferral period), then no change is allowed under Sec 444. • Grandfather rule. For an entity’s first tax year beginning after 1986, the entity was allowed to keep the same year it had for the first tax year beginning in 1986, with the use of a Section 444 election; therefore, older S corporations may still have fiscal years with a deferral period of up to 11 months under this grandfather rule. See Code Sec. 444(b)(3).

17. Textbook Problems Beginning on Page 417

18. Pg 417/418 Problem (a) • All shareholders must consent; A,B,C, and D. • If B sold to G prior to the election, both B and G’s consent is needed for an election to be effective for the first tax year (elect before Dec. 18, discussed below). If B does not consent, the election will be effective at the beginning of the second tax year. • If B is a partnership, then Snowshoe cannot elect S status in its first tax year because a partnership is an ineligible shareholder. It must make the election prospectively following the elimination of the partnership. The election would be effective for year two.

19. Pg 417/418 Problem (b) • The election must be made (Form 2553 filed) on or before the 15th day of the 3rd month of the tax year to be effective in the first tax year. • “…the taxable year of a new corporation begins on the date that the corporation has shareholders, acquires assets, or begins doing business, whichever is the first to occur. The existence of incorporators does not necessarily begin the taxable year of a new corporation.” Reg. 1.1362-6(a)(2)(ii)(C).

20. Problem (b) Cont’d • Operations began Oct. 3rd, so I will assume that is the first day of the tax year (more info is needed). • Here, the election must be made on or before December 17 (before Dec. 18). • October 3 + 14 (the third day of the month is treated like day one of the third month, thus 15 days in December takes us to Dec. 17). • See Reg. 1.1362-6 for examples

21. Problem (c) • Because Snowshoe operates a seasonal business (Winter and early Spring), it is one of the rare businesses that would be allowed a fiscal year under Rev Rul 87-57 (discussed on page 95 of the textbook) that conforms to the ski season. • Absent a business purpose for a fiscal year, Snowshoe could make a Section 444 election and adopt a fiscal year with a deferral period of no more than 3 months (Sept, Oct., or Nov.).

22. Problem (d) • No. Under Reg. 1.1362-2(a) and -6(a)(3) revocation can only be made by shareholders who hold more than 50% of the stock (including nonvoting stock); therefore, A alone cannot revoke the election. • That said, A can destroy the S election by transferring a share to his IRA.

23. Problem (e) • This terminates the S election on the date of the sale because Olga is not an eligible S shareholder (a nonresident alien shareholder). • This divides the tax year into a short S year and a short C year.

24. Problem (f) • This is an example of an inadvertent termination and as long as the sale is rescinded (and C agrees to report the income during the period Olga held the shares), I would expect the IRS to agree, per Code Sec. 1362(f), to waive this inadvertent termination. See the IRS criteria in Reg. 1.1362-5. • Without IRS consent, the corporation could not re-elect S status for 5 years per Sec. 1362(g)

25. Problem (g) • No Change. • Excess passive investment income is only an issue if the S corporation has C corporation earnings and profits. Snowshoe is an S corporation from day one so it does not have any C corporation e&p (absent an acquisition with a Section 381 e&p attribute carryover).