Recurring problems with many S corporations include the untimely discovery of a failure to timely file an S election, filing of an inadvertently invalid election, or inadvertent termination of a previously valid S election. Often times many years will have passed before discovery of an ineffective or inadvertently terminated S election. Absent relief, the termination of an S election can have severe consequences, particularly where the corporation has been making regular distributions. Because this is a pervasive problem under the election requirements of Subchapter S, Congress granted the IRS the power under § 1362(f) to waive invalid or inadvertently terminated S elections provided that certain requirements are satisfied:
- The IRS determines that the termination or invalidity was inadvertent;
- Within a reasonable period of time after discovery of such problem steps are taken to qualify the corporation for an S election, or as a Qsub, as the case may be;
- The corporation and shareholders agree to adjustments that the Commissioner may require for the period of such invalid or inadvertent termination of the election; and
- Except where automatic relief is available under Rev. Proc. 2013-30, §1362(f) relief is sought through the filing of a private letter ruling request with the IRS national office, and payment of the required user fee.
Automatic Relief Under Rev. Proc. 2013-30
In the case of a late or no S election, QSST election, ESBT election, or QSUB election, automatic relief may be available under Rev. Proc. 2013-30, so long as:
- The corporation intended to be an S corporation as of a certain date;
- Relief is requested within three years and seventy-five days after the intended effective date;
- The failure to qualify as an S corporation was solely because an S election, QSST election or ESBT election was not timely filed or a QSUB election was not timely filed;
- The corporation had reasonable cause for the failure to make a timely election; and
- All of the applicable procedural requirements of Rev. Proc. 2013-30 are satisfied.
Section 5.04 of Rev. Proc. 2013-30 provides that the three year and 75 day limitation on granting relief will not apply if certain enumerated requirements are satisfied.
Private Letter Ruling Relief
If the requirements of § 1362(f) are satisfied, but automatic relief is unavailable because steps were not timely taken to qualify for relief under Rev. Proc. 2013-30, or the facts do not satisfy other requirements of the Rev. Proc, relief is only available through the filing of a private letter ruling request with the IRS national office.
Common Invalid election or inadvertent termination S corporation scenarios for which relief has been granted under §1362(f) by private letter rulings include the following:
- A QSST or ESBT election was not timely filed (by the beneficiary, in the case of a QSST, or by the trustee, in the case of an ESBT) [PLR 201528028];
- The S election terminated because stock ownership passed to a nonqualified shareholder, such as a partnership or LLC treated as a partnership for tax purposes [PLR 201813012; PLR 201706001];
- Various rulings have addressed situations in which an entity was either formed as a state law limited partnership or LLC, or later converted to a limited partnership or LLC, coupled with an election to be taxed as a corporation and an S election. However, the partnership or LLC agreement provided for maintenance of capital accounts and allocations and distributions that were inconsistent with the single class of stock requirements that distributions be in accordance with stock ownership. Thus, the election was either invalid or terminated on the subsequent conversion. [PLR 201840004; PLR 201706001];
- The grantor trust status of a trust shareholder was terminated other than by death of the grantor and either a QSST election, if available, or ESBT election, was not made within the sixteen day and two month period beginning on the date of termination of grantor trust status (Reg. §§ 1.1361-1(j)(6)(iii) and 1.1361-1(m)(2)(iii)) [PLR 201636013];
- The grantor trust status of a trust shareholder was terminated by death of the grantor and an ESBT election was not made within two years from the date of death of the grantor (§ 1361(c)(2)(A)(ii)) [PLR 201544006; PLR 201613004];
- Failure to make a QSST or ESBT election within two years from the date on which stock was transferred to a trust pursuant to the terms of will (§ 1361(c)(2)(A)(iii)) [PLR 201527008];
- Consent to the S election by a QSST was erroneously made by the trustee, rather than by the income beneficiary, as required [PLR 201729016];
- Failure of the S election to contain signatures of spouses who held a community property interest in the stock [PLR 201531008];
- Shareholder consent by a grantor trust was erroneously signed by the trustee, rather than the deemed owner [PLR 201537001];
- A QSST became an ineligible shareholder when it failed to satisfy the QSST income distribution requirements [PLR 201716004];
- An S corporation with prior C corporation E&P had passive investment income in excess of 25% of gross receipts for three consecutive years, resulting in a termination of the S election [PLR 201629001];
- S corporation stock was owned by an LLC which was, in turn, owned by an individual and his grantor trust and therefore disregarded. On the individual’s death the trust ceased to be a grantor trust and the LLC automatically became a partnership between the estate and the trust, for tax purposes, thereby terminating the S election. The corporation redeemed the shares held by the estate in order to qualify for the ruling [PLR 201730002];
In each of these rulings the ruling was conditioned upon restructuring, as applicable, such that the corporation qualified to be an S corporation. In the case of ownership by an ineligible shareholder, that restructuring generally took the form of a divestiture of such stock to an eligible owner.
The IRS typically will require that the corporation and shareholders make adjustments, as necessary, for the interim years since the termination. For instance, in the case of a failure to file a timely ESBT election and failure of the trusts to file returns consistent with an ESBT, the IRS will typically require that amended tax returns be filed for open years and any tax difference and accrued interest be paid within 120 days of the ruling. In the event that the statute of limitations on assessment has lapsed on any of such interim years the IRS typically will still require that the tax difference and accrued interest for such barred years nevertheless be paid as a condition of the ruling. In the case of a failure of a QSST to make an income distribution, the trust is generally required to make such distribution(s) to the income beneficiary. In the case of three consecutive years of excess passive income by an S corporation with C corporation E&P the IRS will generally require that the E&P be distributed.
Unfortunately, the current user fee for a private letter ruling seeking relief under § 1362(f) is $30,000. The typical time for receipt of the letter ruling is six months from the time of submission of the ruling request.
For any questions regarding S election relief under § 1362(f), please contact Tom Hineman at 214-744-3700.