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S Corporations: Formation and Termination (Portfolio 730)

Tax Management Portfolio, S Corporations: Formation and Termination, No. 730-3rd, reviews the rules regarding the formation and termination of S corporations.

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Tax Management Portfolio, S Corporations: Formation and Termination, No. 730-3rd, reviews the rules regarding the formation and termination of S corporations. It examines the eligibility requirements which need to be met and the mechanics of filing the S corporation election form and shareholder consents, including the procedures for filing late S corporation elections and late shareholder consents. It also discusses the various ways an S corporation election may be terminated — either voluntarily or involuntarily — and the mechanisms for obtaining relief for an inadvertent termination and for obtaining permission to re-elect to be an S corporation within five years of a termination.

The Portfolio provides practitioners with an analysis of the legislative history behind the S corporation Code provisions. The Portfolio also discusses current state and local taxation issues confronting S corporations. For additional discussion of S corporations, see 731 T.M., S Corporations: Operations.


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AUTHORS

SAMUEL P. STARR
Samuel P. Starr, B.S., Pennsylvania State University; J.D., University of Virginia; LL.M. in Taxation, Georgetown University Law Center; Partner, PricewaterhouseCoopers LLP, specializing in S corporation and partnership taxation; former chair, AICPA S Corporation Committee; former co-chair, ABA Tax Section Task Force on Taxable and Tax-Free Acquisitions Involving S Corporations; adjunct professor, Georgetown University Law Center; departmental editor, Journal of Taxation and Business Entities; lecturer at various tax institutes.

GREG W. SMITH
Greg W. Smith, B.S., Utah State University; M.S. T., University of Utah; Partner, PricewaterhouseCoopers LLP, Private Company Service, specializing in closely-held company tax matters; former member, AICPA, S Corporation Technical Resource Panel.

HORACIO SOBOL
Horacio Sobol, B.B.A, and M. Acc., University of Michigan; Partner, PricewaterhouseCoopers LLP, National Tax Services Office, Mergers and Acquisitions Group, specializing in corporate transactions and S Corporations; member and co-chair, AICPA, S Corporation Technical Resource Panel; contributor to various tax journals and lecturer at various tax seminars.

TABLE OF CONTENTS

Detailed Analysis

I. Introduction

Introductory Material

A. The Subchapter S Corporation (Pre-SSRA)

1. Tax Consequences of the Former Subchapter S Corporation

2. Pitfalls Burdening the Former Subchapter S Corporation

B. The S Corporation (SSRA)

1. New Subchapter S Enacted

2. Compared to Regular Corporation and Partnership

3. Effect of SSRA Rules on Former Subchapter S Corporations

C. The Tax Reform Act of 1986

D. Legislation After the 1986 TRA and Before the 1996 SBA

E. The Small Business Job Protection Act of 1996

F. The American Jobs Creation Act of 2004

G. The Gulf Opportunity Zone Act of 2005

H. The Small Business Work Opportunity Tax Act of 2007

II. Qualification as a Small Business Corporation

A. General Rules of Eligibility

B. Domestic Corporation Requirement

C. Eligible and Ineligible Corporations

1. Member of Affiliated Group - Tax Years Beginning After 1996

a. In General

b. Dividends Received from a C Corporation

c. Qualified Subchapter S Subsidiary

(1) In General

(2) The QSub Regulations

(3) The QSub Election

(4) Effect of QSub Election

(5) Termination of QSub Election

(6) Special Rules

(7) QSubs and EINs

2. Member of Affiliated Group - Tax Years Beginning Before 1997

a. In General

b. Exception for Inactive Subsidiaries

c. Exception for Transitory Subsidiaries

d. Exception for Inadvertent Terminations

e. De Facto Liquidations

3. Financial Institutions

a. Tax Years Beginning After 1996

(1) In General

(2) Passive Investment Income Rules

(3) Interest Expense Disallowance

(4) Mark-to-Market Rules

(5) Director Stock

b. Tax Years Beginning Before 1997

4. Insurance Companies

5. DISCs, Former DISCs, and Foreign Sales Corporations

a. SSRA Grandfather Rule

b. Foreign Sales Corporations and the Extraterritorial Tax Regime

D. Shareholder Limit

1. Number of Shareholders

2. Rules for Counting Shareholders

a. Husband and Wife

b. Family Members

c. Other Shareholders

E. Eligible Shareholders

1. Trusts

a. Background

b. Grantor and Section 678 Trusts

(1) General Rules

(2) Trusts Held at Death

(3) Grantor Trust Planning

(4) Grantor Trust Rulings

c. Testamentary Trusts

d. Voting Trusts

e. Qualified Subchapter S Trust (QSST)

(1) Definition

(2) Income Distribution Requirement

(3) Beneficiary Election and Substantial Compliance

(4) Successive Income Beneficiaries

(5) Minor Beneficiaries

(6) Revocation

(7) Community Property States

(8) Planning

(9) Sample Rulings

f. Electing Small Business Trust (ESBT)

(1) Eligibility and Electing ESBT Status

(2) ESBT Beneficiaries

(3) ESBT Taxation

(4) ESBT Distributions

(5) Terminating ESBT Status

2. Estates

a. General

b. Decedents

c. Bankruptcy

3. Partnerships and LLCs

4. Split Interests

5. Escrow Accounts

6. Nonresident Aliens

7. Agency Relationships

8. Individual Retirement Accounts

9. Momentary Ineligible Shareholders

10. Eligible Exempt Organizations

F. Single Class of Stock

1. General

2. Identity in Distribution and Liquidation Proceeds

3. Voting Rights

4. Disproportionate Distributions

5. Constructive Distributions

6. Stock Issued in Return for Services

7. Incentive Compensation and Other Arrangements

8. Call Options and Similar Instruments

9. Debt as a Second Class of Stock

a. Debt vs. Equity

b. Safe Harbors

(1) Straight-Debt

(2) Short-Term Unwritten Advances

(3) Proportionately-Held Obligations

c. Convertible Debt

d. Special Rules for S Corporations Participating in Capital Purchase Program

10. Stock Purchase Agreements

G. Other Rules

1. Actively Engaged in Trade or Business Not Required

2. S Corporation Election Is Not Tax Avoidance

3. Complete Liquidation Does Not Foreclose Election

III. Electing S Corporation Status

A. General

B. When Effective

C. Filing S Corporation Elections

1. Completing Form 2553 and Complying with its Requirements

a. In General

b. Relief From Inadvertently Invalid Elections And Terminations - Changes Made by the 1996 and 2004 Acts

c. Cases and Rulings Before the 1996 Small Business Act Changes

2. Time for Filing

a. In General

b. Short Taxable Years

c. Compliance with Time Rules

(1) Pre-1996 Small Business Act Law

(2) Changes Made by the 1996 Small Business Act

d. Changing Taxable Year to Start New Election Period

(1) Existing Corporations

(2) Newly Formed Corporations

e. New Corporations: Two-Month-and-15-Day Election Period

(1) Beginning of Two-Month-and-15-Day Election Period

(2) Determining End of Two-Month-and-15-Day Period

(3) Validity of Elections Before Corporate Existence

f. Authority to Treat Late Elections as Timely

(1) Automatic Relief - Revenue Procedure 97-48

(2) Simplified Procedures

(a) Revenue Procedure 2003-43

(b) Revenue Procedure 2004-48

(c) Revenue Procedure 2004-49

(d) Revenue Procedure 2007-62

3. Proof of Filing

D. Shareholder Consents

1. General

2. Consent Procedure

3. Extension of Time for Filing Consents

4. Who Must Consent

a. Beneficial Ownership Controlling

b. Joint Ownership

c. Minors

d. Trusts and Estates

e. Creditors

f. Power of Attorney

E. Effect on Taxable Year

F. New Election After Termination

1. General

2. Five-Year Waiting Period

3. Meaning of “Successor Corporation”

4. Obtaining IRS Consent for New Election

5. Illustrative Rulings

IV. Terminations: S Corporation Status and Shareholder Interests

A. General

B. Voluntary Revocations

1. Form of Revocation

2. When Effective

3. Withdrawing a Revocation

4. Other Rules

C. Ceasing to be a Small Business Corporation

1. General

2. Passive Income Terminations

3. Termination and Ineffectiveness Waivers

4. Intentional Terminations

D. Tax Effects of Revocations and Terminations

1. S Termination Year

2. Allocation of Income and Loss Items

a. Pro Rata Allocation

b. Per Books Allocation

c. S Corporations as Partners in Partnerships

3. Timing of Pass-Through Items

4. Post-Termination Transition Period

a. General

b. Suspended Losses at Date of Termination

c. Cash Distributions After Termination

(1) S Corporation Earnings

(2) New and Former Shareholders

(3) Previously Taxed Income (PTI)

5. Estimated Taxes of Post-Termination C Corporation

a. Estimated Tax Rules - Pre-SSRA

b. Estimated Tax Rules in General

c. Allocating Income to the Short C Year

d. Timing of First Post-S Corporation Payment

e. Flow-Through of Income in S Termination Year

6. Other Effects

a. Re-Election of S Corporation Status

b. Investment Tax Credit Recapture

E. Termination of Shareholder Interests

1. Limitations on Transfers

2. Allocation of Income and Loss Items

a. Making the Section 1377(a)(2) Election

b. Tax Effect of the Section 1377(a)(2) Election

(1) In General

(2) Tax Years Beginning Before 1997

3. AAA and Distributions

4. Fiscal Year Corporations and Flow-Through Income

5. AAA Nontransferable

6. Previously Taxed Income (PTI)

7. Investment Credit Recapture

V. Formation and Capitalization

A. Capitalizing the S Corporation

1. Gain or Loss to Shareholders

2. Basis in Stock

3. Investment Company Restriction

4. Single Class of Stock Requirement

5. Interest to Carry Stock

a. Interest Classification

b. Indirect Investment

c. Direct Investment

d. C to S Conversions

e. Alternative Minimum Tax

6. Section 1244 Stock

7. Indebtedness Contributed to Capital

8. Elections at the Corporate Level

B. C Corporations Converting to S Status

1. Special Rules for Former C Corporations

2. Accumulated Earnings and Personal Holding Company Taxes

3. Investment Credit Recapture

C. Partnership Incorporation and S Corporation Election

D. Selection of Taxable Year

1. General

2. The § 444 Election

a. What Entities Can Make the § 444 Election

b. When the Election Is Not Required

c. What Taxable Year Can Be Elected

d. Transition Rules

e. Making the Election

f. Termination of Election

3. Required Payments

a. Computing Required Payments

(1) Basic Formula - No Applicable Payments

(2) Applicable Payments

b. Other Rules Regarding Required Payments

c. Refunds and Interest

d. Collection and Penalties

e. Tiered Structures

f. Comparison Between Section 444 Election and Using Calendar Year

4. Adopting, Changing, or Retaining a Taxable Year After May 9, 2002

a. Automatic Approval Procedures

b. Nonautomatic Approval Procedures

5. Establishing a Business Purpose Year Prior to May 10, 2002

a. Natural Business Year - The 25% Test

b. The Ownership Tax Year Test

c. The Facts and Circumstances Test

6. Procedural Requirements Prior to May 10, 2002

a. Expeditious Approval Provisions

(1) Who May Use the Provisions?

(2) Conditions

b. Grandfathered Fiscal Years

7. 52-53-Week Taxable Years

E. Adoption of Accounting Methods

VI. Procedural Issues

A. S Corporation Consistency Requirement for Post-1996 Years

B. Unified Audit Rules for Pre-1997 Years

1. Unified Audit Rules

a. General Procedural Rules

b. Subchapter S Items

c. Inconsistent Treatment

d. Designated Representative

e. Small S Corporation Exception

f. Notification Procedures

g. Statute of Limitations

h. Audit Proceedings

i. Litigation Restrictions

j. Requests for Administrative Adjustments

2. Other Procedural Issues

C. Penalties Applicable to S Corporations

1. Failure to File and Failure to Pay Tax

2. Substantial Understatement

3. Aiding and Abetting in Understating Tax Liability

4. Failure to Timely File or Provide Required Information

VII. State and Local Taxation

A. General

1. Corporate Taxes

a. Nexus

b. Structure

2. Individual Taxes

a. Residency

b. Structure

B. State Taxation of S Corporations

1. Recognition of S Corporation Status

2. Taxing S Corporations

a. Nonrecognition

b. Recognition of the S Corporation Status

c. Other Business Taxes Affecting S Corporations

C. State Taxation of Shareholders

1. General Principles

2. Special Rules for Nonresident Shareholders

a. Withholding

b. Taxes Paid on Behalf of the Nonresident Shareholder

c. Information Returns and Registration

3. Credits for Taxes Paid to Other States

a. Taxes Paid by the S Corporation

b. Taxes Paid by Residents to Another State

c. Taxes Paid by Nonresidents to Another State

D. Composite Returns

E. Sales of S Corporation Stock

F. Termination of S Election

1. Causes of Terminations

2. Treatment of the S Termination Year

3. Post-Termination Transition Period

4. Re-Election of S Status After Termination

G. Model S Corporation Income Tax Act


WORKING PAPERS

Working Papers

Table of Worksheets

Worksheet 1 Legislative History of Subchapter S Revision Act of 1982

Worksheet 2 S Corporation Election

Worksheet 3 Extension of Time to File S Corporation Election Consents

Worksheet 4 Shareholders' Consent Statement to S Corporation Election

Worksheet 5 Qualified Subchapter S Trust Election by Beneficiary

Worksheet 6 Successive Income Beneficiary - Affirmative Refusal to Consent to QSST Election

Worksheet 7 Statement of Revocation of Election

Worksheet 8 Shareholders' Statement of Consent to Revocation of Election

Worksheet 9 Notification of Termination of Election by Reason of Corporation Ceasing To Be a Small Business Corporation

Worksheet 10 Election to Close Books upon S Corporation Termination

Worksheet 11 Election to Close Books upon Termination of Interest by S Corporation Shareholder

Worksheet 12 Corporate Adoption of S Corporation Status

Worksheet 13 Corporate Revocation of S Corporation Status

Worksheet 14 Election Under § 1368(e)(3) to Source Distributions First from Accumulated Earnings and Profits Then From Accumulated Adjustments Account

Worksheet 15 Shareholder Consent to an Election Under § 1368(e)(3) to Source Distributions from Accumulated Earnings and Profits Before Accumulated Adjustments Account

Worksheet 16 Electing Small Business Trust Election (Regs. § 1.1361-1(m)(2)(ii))

Worksheet 17 Election to Terminate Year Under Regs. § 1.1368-1(g)

Worksheet 18 Sample Late QSST Election Pursuant to Rev. Proc. 2003-43, 2003-23 I.R.B. 998

Worksheet 19 Preamble to IRS Final and Temporary Regulations on Election, Revocation, and Termination of S Corporation Status

Worksheet 20 Preamble to IRS Final Regulations on One Class of Stock Requirement

Worksheet 21 Preamble to IRS Final Regulations on Definition of S Corporation under § 1361

Worksheet 22 Preamble to IRS Proposed and Final Regulations Under § 1377

Worksheet 23 Preamble to Proposed Regulations on S Corporation Subsidiaries

Worksheet 24 Preamble to Proposed Regulations on Electing Small Business Trusts

Worksheet 25 Preamble to Final Regulations on Pass-Through of S Corporation Items to Shareholder under § § 1366, 1367 and 1368

Worksheet 26 Notice 97-49, 1997-2 C.B. 304

Worksheet 27 Rev. Proc. 97-48, 1997-2 C.B. 521

Worksheet 28 Preamble to Final Regulations on Electing Small Business Trusts

Worksheet 29 [Reserved.]

Worksheet 30 Rev. Proc. 2003-43, 2003-23 I.R.B. 998 (Simplified Relief for Late S Corporation, QSub, ESBT and QSST Elections)

Worksheet 31 Rev. Proc. 2004-48, 2004-32 I.R.B. 172 (Simplified Relief for Late S Corporation Election and Late Corporate Classification Election)

Worksheet 32 Rev. Proc. 2004-49, 2004-33 I.R.B. 210 (Simplified Relief for Late Q Sub Election)

Bibliography

OFFICIAL

Statutes:

Treasury Regulations:

Committee Reports:

Treasury Rulings:

Cases:

UNOFFICIAL

Books:

Periodicals:

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