The general definition of an S corporation includes restrictions on the type and number of shareholders as well as the type of corporation that may qualify for the election. If an S corporation violates any of these restrictions, its S status is automatically terminated.
Inadvertent involuntary terminations should be addressed immediately upon discovery. The taxpayer can request an inadvertent termination ruling under Sec. 1362(f) and, subject to IRS approval, retain its S status.
Involuntary Terminating Events
An S corporation election may be terminated involuntarily if the entity ceases to qualify as a small business corporation under the criteria listed in Sec. 1361(b) or if its passive income exceeds the passive income limitation in Sec. 1362(d)(3).
A corporation’s S election terminates effective on the date that the company commits the act that triggers the ineligibility. If a corporation does not qualify as an S corporation on the first day its S election is supposed to go into effect, its election is treated as terminating that day. After a termination, the corporation is not eligible to elect S status for five years.
In the event of a termination, the corporation should attach to its return for the tax year in which the termination occurs a notification that a termination has occurred and the date of the termination (Regs. Sec. 1.1362-2(b)(1)).
Relief for Inadvertent Termination
If an S corporation inadvertently terminates its S corporation status, the IRS may grant relief. The corporation must be able to demonstrate that the termination was inadvertent. The IRS may provide relief to corporations (via a waiver) and potentially restore S status retroactively, if the following are present:
- The corporation previously made a valid S election and that election terminated;
- The subchapter S election qualification loss was triggered by an inadvertent act;
- The IRS determines that the termination was inadvertent;
- Steps are taken within a reasonable period to correct the condition that rendered the corporation ineligible to be an S corporation; and
- The corporation and persons who were shareholders during the period of the termination agree to make any adjustments the IRS requires that are consistent with the treatment of the corporation as an S corporation (Regs. Sec. 1.1362-4(a)).
The IRS determines whether a termination or invalid election was inadvertent. The corporation has the burden of establishing that, under the relevant facts and circumstances, the IRS should determine that the termination or invalid election was inadvertent. The fact that the terminating event or invalidity of the election was not reasonably within the control of the corporation and, in the case of a termination, was not part of a plan to terminate the election, or the fact that the terminating event or circumstance took place without the corporation’s knowledge, notwithstanding its due diligence to safeguard itself against such an event or circumstance, tends to establish that the termination or invalidity of the election was inadvertent (Regs. Sec. 1.1362-4(b)).
For a detailed discussion of the issues in this area, see “Inadvertent S Corp. Terminations,” by Phillip Elefonte, CPA, in the October 2012 issue of The Tax Adviser.
—Alistair M. Nevius,
The Tax Adviser
Also look for articles on the following topics in the October 2012 issue of The Tax Adviser:
- A discussion of recent estate planning developments.
- A look at recent S corporation developments.
- An analysis of new management strategies in the IRS’s LB&I Division.